Important questions have arisen globally as many countries progress their central bank digital currency (CBDC) research. Interest in CBDCs has grown worldwide since China started testing a digital version of its renminbi (measured in yuan) in major cities last year.

Many people are wondering whether China’s digitalization of its money, along with other economic trends there, would pose a threat to the US dollar’s hegemony as a reserve currency.

Well, even though such claims can seem fanciful at this stage, CBDC technologies have the potential to change the world economy.

What are Reserve Currencies? And How will it affect the United States?

A reserve currency is a foreign currency that central banks typically keep in their foreign exchange reserves. Reserves are held for a variety of purposes, including financing financial investments and preserving interest in the domestic currency.

Reserves are denominated in internationally traded currencies. For years, the US dollar has been the world’s dominant reserve currency. This is in accordance with its widespread international use as the most traded currency on foreign exchange markets and the most often used currency for trade invoicing.

What Factors Decide a Currency’s International Status?

While several geopolitical considerations influence reserve currency status, the issuer country’s economic size and supremacy in international trade play important roles in achieving it.

Why is China a Threat?

Some economists argue that China seems to have the requisite “hardware” to compete with the US dollar as the global reserve currency. China has overtaken the United States as the world’s biggest trader, and according to International Comparison Programme figures, China’s GDP was $19.6 trillion in 2017 by buying power parity, surpassing the United States’ $19.5 trillion.

Some analysts conclude that GDP at current exchange rates is a stronger indicator of geopolitical strength. According to some reports, China will replace the United States as the globe’s largest economy by 2028.

According to an International Monetary Fund (IMF) report, the emergence of digital currencies and advances in payment systems may shift the importance of conventional reserve currency drivers, resulting in the emergence of new reserve currencies.

The data on China’s economy described above must be read in conjunction with other recent developments in the People’s Republic of China. China has made internationalization of the renminbi a policy aim. Beijing’s efforts resulted in its inclusion in the IMF’s Special Drawing Rights currency basket in 2016.

Beijing is pursuing CBDC research aggressively as part of its efforts to internationalize its currency. China’s retail CBDC study is thought to be at an advanced level. China began testing a version of its digital renminbi for retail use in four major cities in April 2020.

China has also teamed up with the central banks of Hong Kong, Thailand, and the United Arab Emirates to create a prototype for real-time cross-border transfers using CBDCs.

How will Digital Yuan Affect the World Economy on Wider Horizon?

The introduction of a digital renminbi for cross-border payments may allow China’s financial system to minimize its dependence on the US dollar while also limiting international financial institutions’ participation and supervision.

Cross border payments are currently expensive and time-consuming due to the presence of many parties, exposing parties to credit and arbitration risk.

China’s CBDC may be appealing for foreign trade if it can use its first-mover advantage to satisfy the need for a digital currency and develop an integrated CBDC infrastructure that can solve these pain points in cross-border payments.

Measures like China’s Belt and Road Initiative and bilateral trade relations with countries, especially in the Southeast Asian region, support the potential opportunities offered by a digital renminbi for enhancing China’s dominance in global financial markets.

Via trade and investment links, this area is inextricably linked to China, and Beijing will most likely use these to fuel demand for a digital renminbi.

Some also claim that a digital currency would encourage China’s CBDC infrastructure to escape US sanctions and users to avoid the SWIFT system’s scrutiny. This may be relevant for sanctioned countries such as Russia, Iran, and Venezuela. Of course, this may be the cause of concern.

These developments, however, seem insufficient to replace the US dollar as the world’s reserve currency. The integrity of the issuer’s policy, as well as the depth and liquidity of its capital markets, are critical.

Capital controls, protectionist practices, and a lack of transparency have all been cited as factors undermining foreign investor interest in China. Unless and until Beijing addresses these questions, a CBDC will not be able to pose a serious threat to the US dollar.

Author: Ananya Narang