What would be the impact of China’s digital currency?

China’s digital currency project is possibly the world’s most advanced. The Digital Currency Electronic Payment (DC/EP) can bring consumers many benefits but may impact banks and existing third-party payment platforms. Yet, if successfully deployed, the DC/EP may bring China one step closer to its goal for Yuan internationalisation.

There is a saying that cash is king, but an increasing number of governments and central banks are beginning to think about entirely cash-free societies. In fact, a recent Bank of International Settlements (BIS) survey of 66 central banks found that 80% were working on a digital currency.1

The COVID-19 outbreak may have also prompted central banks to have a rethink on digital currencies as cash was viewed as a possible transmission channel of the virus. There were also concerns of a scenario where a pandemic may disrupt the existing payment system, requiring a digital backup.

In October 2020, a group of seven central banks, including the Federal Reserve and the BIS, published a report laying out guiding principles for central bank-issued digital currencies.2 Tech companies like Facebook are also flirting with digital currencies.

But perhaps no digital currency project has received more attention than China’s. The Digital Currency Electronic Payment (DC/EP) has just been tested out in the tech hub of Shenzhen, with 50,000 residents receiving digital "red packets" worth about CNY200 (USD30), which they could download to an app and spend at more than 3,000 stores.3

China’s digital currency project is possibly the world’s most advanced, although the People’s Bank of China (PBoC) has yet to indicate when it will be available to everyone.

What is a digital currency?

The DC/EP differs significantly from a cryptocurrency, which is by definition not controlled by any central authority. And unlike a cryptocurrency, it is merely a convenient way to store value rather than something investors can try to make money from.

In fact, DC/EP is simply a digital version of China’s existing currency, the Yuan. It is issued and backed by the central bank. When it becomes available, users will be able to download digital wallets where they can store their money, and which generate a QR code that can be scanned by vendors.4

It will function in a similar manner to Alipay and WeChatPay, the leading digital payments solutions in China. The main advantages for consumers is convenience, lower transaction costs and the ability to transact even without a mobile network.

DC/EP will also allow for better statistical modelling and economic data. Commercial banks are expected to play a role in distributing the digital currency to users. Along with the central bank, they will keep databases to monitor how the digital yuan moves between users, something that is far more difficult to do with cash. While this is expected to help combat money laundering and terror financing, it has also raised concerns that the DC/EP would compromise the data anonymity feature that comes with cash. On this front, the PBoC has indicated that it would strike a balance between protecting anonymity and detecting illegal activities.   

The Yuan’s international ambitions

China’s desire to internationalise the Yuan is no secret, but the DC/EP project has accelerated against the backdrop of rising US-China tensions.

The DC/EP will initially only be used for payments within China. This is however likely to change over time, especially with the development of China’s Cross-Border Interbank Payment System (CIPS), which allows Yuan-denominated transactions to bypass the western-dominated SWIFT system for international payments.

In 2019, CIPS processed CNY135.7 billion (USD20.4 billion) a day from about 980 financial institutions in 96 countries. That makes it small compared to SWIFT, which is dominated by the USD and processed around USD5-6 trillion per day.5 Fig. 1.

Fig. 1. CNY’s share as an international payments currency

Digital currency chart-01

With the US having used SWIFT to enforce sanctions, the CIPS may give the Chinese government an alternative in the long term.

Also, smaller developing countries that have strong trade and financial links with China may start to invoice and settle transactions directly in Yuan. This is particularly relevant for the partners in China’s Belt and Road Initiative. At present, free trade zones throughout China are exploring cross-border financing, and in the future these free trade zones could serve as drivers for the international use of the digital yuan.

Overseas consumption by Chinese tourists and travelers could further expedite the use and circulation of the digital yuan abroad, in turn driving the establishment of corresponding systems and coordinating mechanisms abroad.

Investor concerns

There are some concerns about the way a digital currency may work in practice. In Sweden, for example, there was a backlash to the rapid move to cashless transactions from the elderly and disabled, who have struggled with the transition. In fact, the Swedish government even backtracked and forced banks to provide a minimal level of cash services.6

Financial disintermediation

But the main concerns go beyond the logistics of changing from one form of payment to another. A far bigger worry may be what critics call ‘disintermediation’ - the possibility that commercial banks could be cut out of their traditional role.

Currently, central banks already deal in digital currencies, but only at a wholesale level. Their customers are other banks instead of millions of individuals and businesses.

To some customers, a PBoC-based DC/EP may be seen as a lower risk alternative versus bank deposits. If these bank customers can get their digital currency directly from the central bank, they may be less inclined to deposit it in a commercial bank. Without those deposits, a commercial bank may have less money on hand to lend to other customers. It’s cost of funding may also increase if it has to compete for deposits with other banks or seek other funding sources. There are also concerns that during a banking crisis, the flexible nature of digital currency could result in sudden and massive digital bank runs.7

To address this concern, the European Central Bank has previously suggested limiting the cash-like portion of a possible digital currency to EUR3,000 per person. This is around the median European deposit balance.

China’s approach to managing this problem is to specifically include commercial banks in the distribution of digital currency. It is also likely to impose a size limit for conversion as well as keep the DC/EP non-interest bearing to reduce its attractiveness versus bank deposits. While people will be encouraged to hold DC/EP accounts, the amount in circulation is likely to be managed cautiously, and the impact to the traditional banking system is expected to be marginal, at least in the short term.

Competing payment systems

China already has one of the world’s most mature systems for digital payments. With DC/EP entering a fiercely competitive market, there are concerns how DC/EP would co-exist with the current strong established players.

The most recent figures from the PBoC showed that in 2019, banks handled a staggering USD49.27 trillion worth of mobile digital payments. Roughly four out of every five payments in China are made through Tencent's WeChat Pay or Alibaba's Alipay.8 In Europe, by comparison, around 76% of transactions are still carried out in cash, amounting to more than half the value of all payments.9 Fig. 2. shows that most digital platforms currently use Alipay or WeChat Pay as their payment partner while some have developed their own proprietary system.

Fig. 2. Select large digital platforms and their payment systems

Digital currency chart-02

The attractiveness of these payment systems lies beyond just payments but also in their ecosystems, where they offer a range of services from food ordering to grocery shopping and credit lines.

If the DC/EP offers inter-operability across different payment platforms, this could potentially provide Chinese consumers with greater convenience and drive adoption as the currency in the digital wallet on one payment platform (e.g. Alipay) is currently not accepted on a competing platform.

A Yuan fit for a digital age

Although the technology for a digital currency has existed for some time, the PBoC is likely to take a prudent approach so as not to undermine the broader financial system.

The impact on banks and third-party payments system will depend on the adoption rate of DC/EP and the operating model between DC/EP and these players. While Chinese banks may face some competition for deposits, new opportunities may also arise. Banks can, for example, earn custody fees from customers for their digital wallets. Meanwhile, third-party payment systems must improve the customer experience on their digital wallets to raise the stickiness of their platforms. There probably is room for another payment method in the world’s second largest economy. There are currently about 400 to 500 million individuals without Alipay accounts and another 200 million without bank accounts in China10.

Although China’s DC/EP is still at a pilot stage for domestic usage, the DC/EP can eventually lower the hurdles for Yuan usage in cross border payments. If successfully deployed, the DCEP can enhance the Yuan’s international clout over the long term, moving one step closer to China’s Yuan internationalisation goal. For now, the world will be looking to the 2022 Winter Olympics in Beijing, where China is expected to showcase its digital currency to a global audience.

For Use with Professional Clients / Qualified Investors Only. Not Approved for Further Distribution or Use with the General Public.

The information and views expressed herein do not constitute an offer or solicitation to deal in shares of any securities or financial instruments and it is not intended for distribution or use by anyone or entity located in any jurisdiction where such distribution would be unlawful or prohibited. The information does not constitute investment advice or an offer to provide investment advisory or investment management service or the solicitation of an offer to provide investment advisory or investment management services in any jurisdiction in which an offer or solicitation would be unlawful under the securities laws of that jurisdiction.

Past performance and the predictions, projections, or forecasts on the economy, securities markets or the economic trends of the markets are not necessarily indicative of the future or likely performance of Eastspring Investments or any of the strategies managed by Eastspring Investments. An investment is subject to investment risks, including the possible loss of the principal amount invested. Where an investment is denominated in another currency, exchange rates may have an adverse effect on the value price or income of that investment. Furthermore, exposure to a single country market, specific portfolio composition or management techniques may potentially increase volatility.

Any securities mentioned are included for illustration purposes only. It should not be considered a recommendation to purchase or sell such securities. There is no assurance that any security discussed herein will remain in the portfolio at the time you receive this document or that security sold has not been repurchased.

The information provided herein is believed to be reliable at time of publication and based on matters as they exist as of the date of preparation of this report and not as of any future date. Eastspring Investments undertakes no (and disclaims any) obligation to update, modify or amend this document or to otherwise notify you in the event that any matter stated in the materials, or any opinion, projection, forecast or estimate set forth in the document, changes or subsequently becomes inaccurate. Eastspring Investments personnel may develop views and opinions that are not stated in the materials or that are contrary to the views and opinions stated in the materials at any time and from time to time as the result of a negative factor that comes to its attention in respect to an investment or for any other reason or for no reason. Eastspring Investments shall not and shall have no duty to notify you of any such views and opinions. This document is solely for information and does not have any regard to the specific investment objectives, financial or tax situation and the particular needs of any specific person who may receive this document.

Eastspring Investments Inc. (Eastspring US) primary activity is to provide certain marketing, sales servicing, and client support in the US on behalf of Eastspring Investment (Singapore) Limited (“Eastspring Singapore”). Eastspring Singapore is an affiliated investment management entity that is domiciled and registered under, among other regulatory bodies, the Monetary Authority of Singapore (MAS). Eastspring Singapore and Eastspring US are both registered with the US Securities and Exchange Commission as a registered investment adviser. Registration as an adviser does not imply a level of skill or training. Eastspring US seeks to identify and introduce to Eastspring Singapore potential institutional client prospects. Such prospects, once introduced, would contract directly with Eastspring Singapore for any investment management or advisory services. Additional information about Eastspring Singapore and Eastspring US is also is available on the SEC’s website at www.adviserinfo.sec. gov.

Certain information contained herein constitutes "forward-looking statements", which can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "project", "estimate", "intend", "continue" or "believe" or the negatives thereof, other variations thereof or comparable terminology. Such information is based on expectations, estimates and projections (and assumptions underlying such information) and cannot be relied upon as a guarantee of future performance. Due to various risks and uncertainties, actual events or results, or the actual performance of any fund may differ materially from those reflected or contemplated in such forward-looking statements.

Eastspring Investments companies (excluding JV companies) are ultimately wholly-owned / indirect subsidiaries / associate of Prudential plc of the United Kingdom. Eastspring Investments companies (including JV’s) and Prudential plc are not affiliated in any manner with Prudential Financial, Inc., a company whose principal place of business is in the United States of America.