Research: Rationally understand the central bank's digital currency and the internationalization of the RMB

Source: Sina Finance, Author: OKLink Research Institute

With the smooth progress of the pilot work of the digital currency of the central bank of my country, everyone has high expectations for it. Especially in promoting the internationalization of the RMB, various popular sayings in the market: it is believed that the central bank's digital currency is a mathematical mapping of power. Whoever can take the lead in launching the central bank's digital currency can shake the hegemony of the US dollar, which means "achieving success in one battle". In addition, affected by the tense international situation, people are quite concerned about the potential threat of sanctions from SWIFT, so they hope to get rid of their dependence on SWIFT with the help of DCEP. At present, these views are widely spread in the market and have a significant impact, but many of them are not accurate.

This involves an important issue: how to rationally and accurately understand the central bank's digital currency and the internationalization of the RMB.

Correctly Viewing the Internationalization of the RMB

According to the definition of the Bank for International Settlements [2], currency internationalization means that the use of a currency exceeds that of a country and can be used or held by residents or non-residents of the issuing country at the same time. Chinn and Frankel also compiled a list of international functions of internationalized currencies, as shown in the table below [3]. According to this list, an internationalized currency can provide residents or non-residents with the functions of value storage, transaction medium and account unit. This classification can be used as an evaluation framework for the internationalization of the RMB [4].

Table 1. International currency functions, Source: International Economic Review, OKLink Research Institute

In July 2009, the People’s Bank of China and six other departments jointly issued the “Management Measures for the Pilot Program of RMB Settlement in Cross-Border Trade”, marking the beginning of the internationalization of RMB. After nearly a decade of development, the international use of RMB has steadily increased, and its international currency status has continued to improve. Specifically, the current international development of RMB is as follows[5]:

Table 2. Progress of RMB internationalization, Source: The Progress of RMB Internationalization, OKLink Research Institute

• Value storage function

As a reserve currency for central banks of various countries, it is an important sign that the internationalization of currencies has reached a high level. In 2016, the RMB was officially included in the IMF's Special Drawing Rights (SDR), with a weight of 10.9%, second only to the US dollar (41.7%) and the euro (30.9%), laying a solid foundation for the RMB to become an international reserve currency in the future. However, the role of the RMB as an international reserve currency is not yet obvious. As of the third quarter of 2019, the RMB assets held by global central banks were only US$219.6 billion, accounting for only 2% of global foreign exchange reserves, ranking fifth.

The investment and financing function is also an important path for currency internationalization and the key to promoting the internationalization of the RMB. In terms of direct investment, driven by the Belt and Road Initiative, RMB outbound direct investment has grown rapidly, from 30.4 billion yuan in 2012 to 760 billion yuan in 2019; while RMB foreign direct investment has increased significantly from 253.5 billion yuan in 2012 to 2 trillion yuan in 2019.

Secondly, in terms of securities investment, due to the gradual opening of my country's capital market, the introduction of opening measures such as Qualified Foreign Institutional Investors (QFII), Shanghai-Hong Kong Stock Connect, Shenzhen-Hong Kong Stock Connect, and Bond Connect; at the same time, my country's A shares were included in the MSCI, providing an opportunity for countries to hold RMB assets. According to data from the China Foreign Exchange Trading Center, as of the end of 2019, RMB assets (stocks and bonds) held by overseas institutions and individuals were 2.1 trillion and 2.3 trillion, respectively, accounting for 4.3% and 3.5% of the total domestic stock and bond assets, respectively, reflecting that the RMB as an asset-based currency still has a lot of room for growth in the future.

• Medium of exchange function

The realization of the transaction medium function is divided into two behavioral paths: government and market. At the government level, since the financial crisis in 2008, my country has signed currency swap agreements with many countries such as Thailand, Japan, and South Korea. As of April 2020, the People's Bank of China's currency swap reached 3.47 trillion yuan, a significant increase from 0.65 trillion yuan in 2009.

At the market level, as of the end of 2019, the amount of RMB as a settlement under the current account increased from 3.58 billion yuan to 6.04 trillion yuan, and the proportion of my country's imports and exports also increased from 0.02% to 19%. However, in the international market, other countries use RMB for transactions in international trade at a low rate. As of June 2019, the share of RMB as an international payment currency in global cross-border payments was only 1.99%, and the US dollar is still the main settlement currency.

• Unit of Account

Since the 1980s, the international monetary system has formed a currency anchor dominated by the US dollar, the euro, the yen and other currencies. At present, this monetary system has not been really shaken, and the RMB has not really become an anchor currency. Therefore, in the current international trade system, major trade and financial transactions, especially commodity trade, are denominated in US dollars. In particular, the US dollar, as the pricing currency for crude oil trade, accounts for about 90% of the global oil trade settlement. However, China is also trying to open up the internationalization of the RMB as a pricing currency.

In March 2018, the Shanghai Stock Exchange launched RMB-denominated crude oil futures. By the end of 2019, the trading volume of RMB-denominated crude oil futures accounted for 6% of the global crude oil futures market. In addition, since January 2020, the world's three largest iron ore miners have begun to use RMB settlement in iron ore trade.

Similarly, in the field of bond financing, my country has introduced offshore RMB loans, panda bonds, offshore RMB bonds and other financing tools denominated in RMB. The current stock of panda bonds is about 243.74 billion yuan, a significant increase from 4.63 billion yuan in 2015; however, due to the pressure of RMB depreciation since the second half of 2015, the issuance of offshore RMB bonds has shrunk significantly, and even zero issuance has occurred. The current stock size is about 249.43 billion yuan, which is relatively small.

From the above analysis framework, we can see that although the internationalization process of the RMB has made great progress in the past decade, the RMB has not yet fully played its international currency functions such as value storage, transaction medium, and account unit, and there is still room for further improvement in the future.

Accurately view the relationship between DC/EP and cross-border payments

At present, the market's biggest expectation for the central bank's digital currency lies in the application of DC/EP in the field of cross-border payments, and thereby promoting the internationalization of the RMB.

It is true that digital currency has certain advantages in cross-border payments. Current cross-border payments have problems such as long cycles, high costs, and low efficiency. For example, a current wire transfer usually takes 2-5 working days to arrive, and the handling fee is usually one thousandth of the remittance amount, plus a telecommunications fee of 150 yuan; cross-border payments based on digital currency have obvious advantages, which can not only increase the speed of cross-border transfers, but also reduce the handling fees of remittances. For example, if regulatory factors are not considered, and only from a technical perspective, Bitcoin is used directly for cross-border payments, then it only takes 10 minutes to confirm the completion of the remittance transaction, and only about 10 yuan in handling fees is required; in addition, the current central bank digital currency adopts a loosely coupled account design, which means that users do not need to bind a bank account to make transfers and payments when using the central bank digital currency, which is very attractive to those overseas people in poor and remote areas and those who lack traditional financial infrastructure (banks).

Therefore, based on the above advantages, if overseas people all use DC/EP for cross-border remittances or transaction payments, it will increase the use of RMB in the field of trade settlement.

However, we should also realize that although the above blueprint is beautiful, there may be many limitations in the actual implementation process. These limitations are based on the functions and characteristics of the central bank's digital currency DC/EP, which involves two basic questions: What is the positioning of DC/EP? What are the usage scenarios?

In my country's positioning of the central bank's digital currency, DC/EP is classified as M0, which is well deserved, because the central bank's digital currency is essentially electronic cash, that is, the original cash carrier is changed from paper or metal form to electronic form.

It is precisely because DC/EP is positioned at M0, and based on various considerations, DC/EP is mainly aimed at small retail scenarios, and has restrictions on amount and time when paying according to account categories.

Table 3. Classification of monetary statistics, data source: OKLink Research Institute

In the current increasingly developed international trade, the trade model of using M0 to achieve "money for goods" (i.e. one hand pays the money and the other hand delivers the goods) is gradually decreasing. Foreign traders are more likely to adopt various trade financing models (such as factoring, forfay extension, packaged loans, export bill advances, etc.). The currency generated based on credit in this process belongs to the category of M1, M2 or even M3. It cannot be achieved by relying solely on DC/EP, and requires the support of the country's developed financial market.

Secondly, as we mentioned above, an international currency must occupy a large market share in the settlement and pricing of trade and financial transactions. However, DC/EP is only for small payment scenarios, which means that it is difficult for people to use DC/EP for large payment transactions in the trade field, which limits the role of DC/EP in international trade and financial transaction settlement.

Of course, even if DC/EP does not have the above restrictions, we should not regard the central bank’s digital currency as a “panacea” in the field of cross-border payments, as Zhou Xiaochuan, former governor of the central bank, said:

“The inconvenience of cross-border remittances is not mainly due to technical barriers, technical selection, or technical system barriers, but mainly due to policy and institutional barriers. Once exchange is involved, it involves the coordination of the global exchange rate system. [6]”

In fact, as we mentioned in the previous article, the current problems in the field of cross-border payments are not only technical problems, but also regulatory problems. We know that capital openness and free convertibility of local currencies are prerequisites for the internationalization of a currency, and both involve the stability of my country's financial market and future reforms. Because once a currency is fully internationalized, it means that international hot money can easily obtain the domestic currency. In the case of underdeveloped domestic capital markets, the issuing country of international currency is extremely vulnerable to attacks by international speculators. At present, my country has not yet fully opened its capital account, and it is inevitable that the RMB will have restrictions on cross-border payments. Therefore, we should not simply think that only DC/EP is needed to achieve the free cross-border flow of RMB. This also requires further reforms in my country's domestic financial market (including market-oriented reforms of interest rates and exchange rates), currency convertibility and the opening of capital controls.

Can the launch of central bank digital currency get rid of dependence on SWIFT?

At present, many people believe that the launch of DC/EP will help my country get rid of its dependence on SWIFT. This statement is inaccurate. This requires us to have an accurate view of SWIFT and the current international clearing system.

SWIFT (Society for Worldwide Interbank Financial Telecommunication) is a membership-based professional cooperative organization for the formulation of international interbank payment and collection information message standards and their transmission and conversion, providing members with fast, accurate and excellent message transmission and conversion services for cross-border payment and collection clearing business. Therefore, SWIFT is a multi-currency message processing system and a telecommunications channel in the international clearing system, rather than a payment system.

At present, the international clearing system consists of two parts: one is the cross-border clearing system of national currencies led by each country, such as CHIPS (US dollar cross-border clearing system) in the United States and CIPS (RMB cross-border payment system) in my country; the other is the international payment and collection telecommunications operation system shared by all countries, such as SWIFT. In actual operation, SWIFT is connected with the cross-border clearing systems of various countries to achieve cross-border payment. Taking the United States as an example, the cross-border payment settlement of US dollars requires SWIFT to be connected with CHIPS and another US payment system Fedwire (US dollar large-value payment system). SWIFT provides telegram exchange, CHIPS performs netting and clearing, and finally completes the settlement through Fedwire, as shown below:

Figure 1. US dollar cross-border payment and settlement system, Source: OKLink Research Institute

The central bank's digital currency is essentially a payment system, not a message processing system, so DC/EP cannot replace SWIFT at all. In fact, since 2012, China has begun to build its own cross-border payment system CIPS and has made great progress. Instead of expecting a breakthrough in the field of cross-border payments with DC/EP, it is better to speed up the construction of CIPS in my country. Of course, even the CIPS system still needs to rely on SWIFT. If China really wants to get rid of its dependence on SWIFT, it needs to redevelop a message processing system similar to SWIFT. But the key to the problem is that the message format of SWIFT has become an international unified standard. Starting from scratch means setting up a new standard. How many countries are willing to use this standard is an important issue.

In fact, the current concerns of Chinese people about SWIFT seem a bit redundant. We should clearly realize that SWIFT is an international cooperative organization, not a government department of a specific country. A country's voice in international organizations depends on its comprehensive national strength and international influence. At present, as China has become the world's second largest economy and surpassed the United States to become the world's largest trading country, more and more Chinese companies and institutions have joined SWIFT as members. China has become an increasingly important source of business for SWIFT and has received increasing attention. The United States can use its hegemony to sanction countries such as Iran and Venezuela through SWIFT, but it is difficult to sanction my country through SWIFT.

Figure 2. Changes in total trade volume of major countries in the world, Source: OKLink Research Institute

Correctly understand the relationship between central bank digital currency and RMB internationalization

As can be seen from the above, the internationalization of a country's currency involves value storage, transaction medium and accounting unit, and it cannot be achieved by relying solely on the widespread application of central bank digital currency in the field of cross-border payments. We should also clearly realize that the internationalization of a country's currency depends fundamentally on the comprehensive national strength formed by the country's political, military, economic, financial and technological strength, which is not simply determined by changes in the currency carrier. Just as the reason why the US dollar can become the world currency is behind the credit of the US dollar and the strong comprehensive strength of the United States. As long as the credit of the US government is still there and its comprehensive strength is still strong, the position of the US dollar as the world's dominant currency will not be shaken.

The most obvious example is that in 2018, the Venezuelan government issued a digital currency called Petro, and each Petro was backed by a barrel of Venezuelan crude oil. This has achieved the mapping of "digital and power", but has the Venezuelan government gained the upper hand in seizing financial control? No, in fact, due to the sanctions from the United States and the deterioration of the country's economy, there has been a phenomenon of local residents selling a large number of Petro coins.

Venezuelan Petro

As Professor Yu Yongding, a researcher at the Chinese Academy of Social Sciences, president of the China Society for World Economics, and member of the United Nations Development Policy Committee, said: "The primary determinant of the renminbi's ability to become an international currency is China's growing importance to the world economy. The growing size of China's economy will strongly support the renminbi to play a greater role in the world... In addition, China also needs to promote domestic financial market reforms, the development of the offshore renminbi market, establish a more flexible renminbi exchange rate, and open up its capital account."

Therefore, to truly realize the internationalization of the RMB, we need to further promote market-oriented reforms and opening up in my country's economic and financial fields, and improve my country's global economic status and comprehensive national strength. If we only rely on the advantages of DC/EP in the field of cross-border payments to internationalize the RMB, it is unrealistic to hope to achieve "one victory in one battle".

References:

[1] A central bank official gave a rare public lecture: The world’s concerns about Libra are not groundless, The Paper

[2] Kenen, Peter, "Currency Internationalization -An Overview", Paper, Bok-BIS Seminar on currency internationalization: Lessons from the global financial crisis and prosects for the future in Asia and the Pacific, Seoul, 19-20 March, 2009.

[3] Chinn, Menzien and Jeffrey Frankel, “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” NBER Working Paper No. 11510, 2005

[4] Gao Haimei and Yu Yongding, The meaning and conditions of RMB internationalization, International Economic Review, No. 1, 2010.

[5] Tan Xiaofen and Wang Ruixian, The process, experience and path selection of RMB internationalization, New Horizons: China's Social and Economic Development Strategy, May 2020.

[6] Zhou Xiaochuan: The inconvenience of cross-border remittances is mainly due to policy and institutional barriers, Sina Finance