How China’s digital yuan could work in a dual-currency socialist system

China could split the e-CNY into onshore and offshore versions, have a freely tradeable yuan-pegged stablecoin or participate in a universal CBDC
If China does decide on universal basic income, digital yuan payments could easily be programmed to be spent only on necessities

Simon S.H. Chan

Published: 4:30pm, 28 Nov 2023

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At Hong Kong FinTech Week, there were lively discussions on and demonstrations of the growing uses of China’s digital yuan, the e-CNY. The growing momentum is no surprise. China is the first major economy to roll out a digital currency and a front runner in central bank digital currencies (CBDCs).

But what does this mean under China’s unique dual-currency and socialist system?

CBDCs like the digital yuan function like traditional banknotes but exist entirely in digital form and are registered on a centralised ledger. Their digital nature enables them to be more efficiently distributed and, crucially, programmable – from spending restrictions to triggers and limits.

I have written before about how China, under its socialist system, may embrace the dividends of artificial-intelligence-generated productivity gains to introduce universal basic income.

CBDCs could complement this by ensuring the digital yuan issued under the initiative can only be spent on certain categories such as food, utilities and education, therefore encouraging the working population to remain productive. The government could also programme negative interest rates to boost consumption.

Moving to a CBDC would be relatively straightforward for most currencies. But China has always kept a tight control of the yuan, to shape and protect its economic model. The reins only loosened in 2009, when restrictions were lifted on yuan trade settlements between the mainland and Hong Kong. It was the first time the government had allowed offshore yuan settlements and marked the acceleration of yuan internationalisation.

As a result, two types of yuan emerged. CNY is yuan traded on the mainland market while CNH is yuan traded offshore, such as here in Hong Kong. Both currencies have different foreign exchange rates and don’t trade against each other.

This raises the question of how the digital yuan might exist under this dual-currency system. The most straightforward model is for the People’s Bank of China to simply programme one batch with its usual restrictions for the domestic market, and another without such restrictions, to be traded openly on the global market.

This would give the central bank even greater flexibility in its monetary policies. Yet the premise here is that there has to be absolute trust in the issuer, in this case, the Chinese government, given that it is theoretically possible to directly encode restrictions, even sanctions.

In recent years, the rising use of financial sanctions has prompted some nations to reconsider their reliance on the current correspondent banking system. Correspondent banks serve as intermediaries to make international financial transactions possible between banks that don’t have formal ties.

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The Society for Worldwide Interbank Financial Telecommunication, better known as Swift, is the largest global network of correspondent banks – and also a choke point for the US and others to exercise unilateral sanctions.

Assuming there are common protocols, CBDCs can be directly settled without the need for a clearing house. This not only bypasses restrictions from third parties at choke points but also means transactions are much faster and cheaper. Sanctions are still possible, but only between countries as opposed to freezing a country out of the global financial system.

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Another option is to have a stablecoin pegged to the yuan. Stablecoins are digital currencies designed to maintain a relatively stable price, typically tied to a currency but not sovereign in nature.

They can be backed by cash, cash equivalents or other assets. Unlike CBDCs, stablecoins are issued by private banks or organisations, but they share programmable qualities. For instance, First Digital, a trust and custody company based in Hong Kong, issues the FDUSD, a stablecoin pegged to the US dollar.

Stablecoins can be freely traded on the global market and serve as building blocks for innovative financial and non-financial applications. The Hong Kong Monetary Authority (HKMA) plans to introduce a regulatory framework for stablecoin by next year. Such regulation could pave the way for stablecoin to integrate with the financial system and importantly, have exchangeability with CBDCs.

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If a yuan-backed stablecoin gains traction as a market-driven alternative to an offshore digital yuan, free from state control, it could further accelerate the internationalisation of the yuan.

There is one more possibility: a universal CBDC. This would not be tied to a specific local currency but backed by a basket of currencies, accepted by all participating central banks. Conversion into local currencies would be based on rates determined by central banks or exchanges. China could be bold and fully commit to an universal CBDC as its offshore currency – but it is more likely that it will merely participate.

Sanctions would be challenging with a universal CBDC, as it would require cooperation from all participating countries. Alliances like Brics (a bloc founded by Brazil, Russia, India and China, with South Africa joining later) are testament to the growing numbers of countries seeking alternative, more equitable trade relationships. A universal CBDC could prove highly appealing.

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Hong Kong is the world’s largest offshore market for yuan settlement, while also fostering the growth of its Web3 industry and integrating digital assets like CBDCs and stablecoins into its financial system.

The mBridge alliance, for instance, is a collaboration between the Bank for International Settlements, HKMA and the central banks of China, Thailand and the United Arab Emirates, aimed at exploring the applicability of CBDCs in cross-border trade.

These developments are important as Web3 technologies hold the potential to reshape trade and finance in an increasingly multipolar world. As digital asset regulation and technology evolve in step with global cooperation among like-minded central banks, we could see some interesting new models emerge.

Simon S.H. Chan is the head of technology of the Greater Bay Area and global lead of Emerge at Edelman