China currently leads the world in the development of a central bank digital currency (CBDC). While most countries are still in the planning stage, China launched a small-scale pilot program for the digital renminbi in 2020. Known as digital currency, electronic payment (DCEP), the blockchain-based currency will be more widely tested this year, including in Beijing, Shanghai and Guangdong Province.

Beijing began developing a CBDC in 2014 in a bid to challenge the paramountcy of the U.S. dollar in the global financial system. Think of it as a fast tracking of the long-running renminbi internationalization policy, adapted for the digital age. If China can build its own digital payment rails that operate globally, it will no longer be dependent on SWIFT and in theory able to transact with whomever it likes.

China's ruling Communist Party has seen how Washington uses its control of the global financial system to punish its adversaries like North Korea, Russia and Iran. To avoid the fate of those countries, the CCP is determined to overcome "dollar hegemony."

China accelerated its CBDC project in the final two years of Donald Trump's presidency as relations with the U.S. soured. In 2020 the U.S. reportedly mulled sanctioning some of China's largest financial institutions amid the trade war and coronavirus pandemic that began in Wuhan. Some Chinese policymakers even feared that Washington would ban China from clearing dollars. 

Those fears never came to fruition. But China is nonetheless determined to roll out DCEP expeditiously with wide testing likely before the 2022 Beijing Winter Olympics. The central bank's immediate concerns pertain more to the domestic market than international use of DCEP. Indeed, the digital yuan will help Beijing reassert state control over China's financial system. The losers in this game will be China's tech giants, the country's erstwhile kingmakers of digital finance.

Beijing did not intend to give platform companies like Alibaba and Tencent a leading role in the banking system. But the government also did not regulate them tightly. Given voracious demand for internet finance, and the weak digital offerings of incumbents, it is no surprise that they became too big for their own good. The abortive Ant Group IPO signaled that China's fintech party was over.

Ant Group and WeChat Pay thrived in part because of their close ties to incumbent financial institutions. Their respective e-wallets, for instance, normally must be tied to Chinese bank accounts.

To curb the power of Ant and WeChat Pay, Beijing may restrict their operability with DCEP. It could limit the DCEP transactions they are permitted to process. Chinese citizens who want to transact in DCEP may then prefer to use other e-wallets provided by banks or one tied to the digital yuan itself.

DCEP also has an offline function - just like cash - and unlike Alipay and WeChat Pay, which cannot operate without an internet connection. "As long as two mobile phones with the digital currency wallets are touched together, transfer of funds can be completed conveniently," Mu Changchun, director of the Central Bank’s Digital Currency Research Institute, said in October.

At the same time, China will use DCEP to keep closer tabs on its people's financial behavior. DCEP will have “controllable anonymity," which means that regulators can monitor transactions while the transacting parties remain private. However, if anything seems awry, the transactions will not stay anonymous for long.

In January, Guo Weimin, an executive at Bank of China, said that the digital renminbi's key virtue was its ability to trace cash flows and make it easier to enforce financial regulations such as those around debt collection.

“There will be a lot of challenges from the pandemic that will make good cases for the use of digital currencies," he said at the Asian Financial Forum in Hong Kong.

Steady as she goes

One of the few countries in the world besides China with a functional CBDC is Cambodia. Phnom Penh launched Project Bakong (a "retail CBDC") in late 2020. Bakong represents a tokenized version of Cambodian riel or U.S. dollars in the Cambodian central bank's reserves.

Bakong has two main functions. The first is to boost financial inclusion through cashless payments in the riel. Cambodia has a large unbanked population, estimated by The World Bank to be 78% of Cambodians aged 15 and up. Bakong will also support Phnom Penh's effort to reduce dependency on the U.S. dollar.

Among major Asian economies, Japan has shown the most initiative to develop a CBDC after China. Tokyo knows that it needs a CBDC to stay competitive with China. A digital yen will also help Japan better digitize its financial system. Currently, just 27% of payments in Japan are cashless.

Japan will start testing CBDC functions such as issuance, distribution and currency design this year. Both the government and private sector will be involved. A group of 30 companies that includes Japan's three largest banks plans to experiment with a digital currency using a common settlement platform.

However, Japan's CBDC launch is still several years away. Japanese policymakers believe that they must first have measures in place to prevent large outflows from private bank deposits.

Compared to Japan, Korea is less eager to develop a CBDC. The Bank of Korea (BOK) does intend this year to study the merits of a digital won, but will not commit to creating a digital fiat currency.

Meanwhile, the U.S. will definitely develop a CBDC, mindful of the need to stay competitive with China. However, the U.S.'s democratic system of governance requires open policy discussions about a digital dollar. The United States Federal Reserve cannot unilaterally announce it will launch a CBDC as the PBoC did. Thus, the process will be slower than in China. That holds true for most democratic nations.

In October 2020, then Deputy Treasury Secretary Justin Muzinich told the Atlantic Council, “It’s something we’re studying … [T]his is really a decision which sits as much with the Fed as it does with Treasury,” he said. 

By moving carefully on its CBDC, the U.S. can learn from the experiences of others. “Since we are the world’s reserve currency, we actually think we need to get this right and we don’t feel an urge or a need to be first," Fed Chair Jerome Powell told Yahoo Finance in January.

Powell raises a salient point. The U.S. remains the premier global reserve currency. Central banks hold 60% of their reserves in dollars and just 2% in renminbi. Morgan Stanley reckons that will rise to 5-10% by 2030, surpassing the levels of the Japanese yen and British pound.

Don't bet on it. China may be allowing more foreign investment in its financial sector, but that is the extent of liberalization efforts. Beijing's reluctance to let its currency float and relax capital controls has prevented global use of the renminbi from meeting the lofty expectations of a decade ago. In the early 2010s, some observers boldly predicted that China's capital account would be fully convertible by 2020.

China's closed financial system will not slow down DCEP's deployment in the domestic market, which is currently the Chinese government's priority. Internationally, the situation is different. Perhaps countries hit by U.S. sanctions (Russia, Iran, Venezuela, North Korea) will be eager to transact on China's closed digital payment rails. But that hardly will strengthen China's role in the broader global financial system.

At the same time, the world does not trust China's financial system and regulatory regime as it does America's. The ruling Communist Party too often sees transparency as a liability, while for the U.S. it is strength. It may take the U.S. a while to launch a CBDC, but when that day comes the digital dollar will enjoy a much higher level of trust than DCEP. Indeed, many countries already worry that the Chinese authorities will monitor every DCEP transaction. What works in China does not necessarily work in the rest of the world.