CBDC : Are we moving to a new banking system post Covid 19

As we tentatively move out of government imposed lockdowns, we are realizing the gravity of the economic mess that we have created ourselves for being so intertwined to each other nationally and across the globe.

Clearly slowdown/recession is something which has started to bite economies of many countries, the counting of losses has already started in earnest. What was thought as a simple switch off and on of the economy has resulted in massive supply chain disruptions. Nearest catastrophe of similar nature if  we compare was the global financial crisis of 2008, we realize that this slowdown is more down to supply constraints rather than demand.

Action by Central Banks

Still the blueprint by every central bank as in 2008 and government has been to issue fiscal stimulus to continue both government and individual spend. The US has announced an stimulus amounting to almost 10% of its GDP  ($21 trn) i.e $ 2 trillion, of which each individual citizen gets almost $1200 and $500 for a child support as part of social security net in lieu of job losses and lockdown restrictions. Rest would be utilised for supporting the industry especially smaller organizations who are expected to retain jobs for getting the central dole. Bank of England, ECB (European central bank), Bank of Japan have all announced similarly sized stimuluses to keep the economic engine running till the lockdown opens. The quote President Trump used was 'The cure need not be as bad the ill'. 

The ill effect of these lockdowns and instability across the globe had led to wholesale dumping of bonds and equities by investors and taking flight to safety in hoarding US dollars. Equities across exchanges have fallen more than 30-40% since March. There have been run-ins on Mutual funds leading to wholesale redemptions. Most Foreign investors are flocking to buy US treasuries as they are considered the safest bets better than even gold. So the humble US dollar has triggered waves of selloffs and destabilised world economy.

US Dollar

Today almost 90% of all international transactions happen in US dollars and almost 60% of worlds foreign exchange reserves are in $. This makes the $ as the defacto currency of the world and every country who does not even deal directly with the US has risks associated with dollar movement as their national banks certainly do. What this has created is a global economy which may go into tailspin if Dollar adversely moves against their national currency. Eg Brazilian Real, Indian Rupee , Yen etc have at times depreciated more than 20-30% creating issues in balance of payment or foreign debt servicing. It severely limits the fiscal stimulus a emerging country like India can announce to arrest the effects of slowdown as it would lead to further ratings downgrade and loss of dollars. Comparatively Chinese currency RMB or renminbi accounts for just 2% of world trade in spite China having trade surplus with many countries due to gigantic exports. Buyers of chinese goods and Chinese sellers both prefer US dollars as currency of exchange.

The geopolitics of this has exacerbated the cold war between the US on China already simmering from 2018 onwards in lieu of trade disputes. The rhetoric has just gone up a notch. The fallout has been so severe that countries are looking at moving their factories out of China to other destinations. Meanwhile China itself holds almost 3 trillion dollars of foreign exchange reserve and more than 60% of it in US treasuries and bonds.

There 2 things which may result if the trade war escalates further

1. US may cancel this massive Chinese debt/default on the interest payments thereby rendering that FX reserves of china redundant and pushing them to the brink.  The US will also suffer a lot on account of ratings downgrade, loss of trade. But being a superpower US may get away with this.

2. Sensing the danger the Chinese have already started to offload US treasuries and bonds in the open market thereby spiking the yields (interest rates) and fall in bond prices. This could adversely affect the US in terms of rising interest rates when almost their debt/gdp ratio is beyond 106%. - source US bureau of public debt

3. The Chinese understanding the risks of global economy dominated by dollar have already started migrating to CBDC's nothing but Central bank digital currency.

Traditional cryptocurrency
Normal Cryptocurrency like Bitcoin  offers an alternative method of storing money and making payments without relying on the traditional banking system and government controls.

So basically rather than using a regulated entity to validate the exchange of money, cryptocurrency uses peer2peer network to validate the exchange using blockchain technology. Each transaction details are stored on a block which stores the transaction value, date, timestamp etc and then this block is linked to a new  transaction block. These blocks are stored on thousands of computers called nodes where each block has multiple copies thereby making it impossible for hackers to edit any block as each block has thousand of copies on thousands of computers thereby not requiring clearing houses from regulators.

CBDC's

Central Bank Digital Currency (CBDC) represents the digital form a fiat currency of a particular nation (or region), and is issued and regulated by the competent monetary authority of the country.

Peoples Bank of China or PBoC will soon issue a digital currency called DC/EP which will enable buyers and sellers to transact using this cryptocurrency which would be backed by RMB currency.  This currency will not be using the underlying  blockchain  technology but a 2 tier approach wherein PBoC will issue the currency to respective banks and they in turn will facilitate it to the  public for circulation thereby replacing cash. The benefit for China is that every financial transaction can be traced and tracked, reducing incidences of money laundering, and reduce overall banking costs. This would also enable them to reduce dollar dependence and increase the speed of international transactions for countries already under BRI or Belt and road Initiative which include 70 countries from Asia, Europe and Africa. As a pilot China will pay 1/3rd of the salary to its employees in digital currency which will further increase the usage in peer to peer network.

The pointed benefits using CBDC's can be gauged from the limitation of current fiat money being currently used, is that fiscal stimulus which takes weeks to reach the current recipient may only take 2-3 days and be targeted and accountable. eg US govt had authorized $1200 to be transferred to each US citizen during the Covid 19 pandemic and in normal course would take 4 weeks to be issued by checks or online account transfer using intermediate banks but this process can be cut to 2-3 days plus reduce the inter-bank transaction charges.

Plus the way today currency is being printed by each government as economic support during this Covid pandemic, it may create a situation in terms value loss of the underlying currency thereby causing widespread inflation similar to Zimbabwe/Venezuela where inflation has touched 600% and they have no option but use digital currency going forward for foreign exchange transactions.

Though only a handful of central banks like Bank of England, Swedish Sveriges Riksbank are keen on migrating partially to CBDC's. It may be forced upon them to go this route as China is looking at upending the hegemony of US dollar and to create an economic ecosystem where it projects its CBDC as an alternative to US dollars

N.B RBI itself is exploring a CBDC's type sovereign digital currency but is against private cryptocurrencies like Bitcoin , Ethereum, Libra by Facebook.