China finds entry point for launching Digital Yuan

Beijing's desire to challenge the dollar's hegemony is real. Using the wealthy to seed Hong Kong's freewheeling, open economy with digital yuan may be its best shot to move closer to that distant goal

China's plan to take its digital currency global may have found a possible starting point: the wealth management industry in Hong Kong.

Last month, the People's Bank of China released detailed instructions on Wealth Management Connect, a program that will allow qualified individual investors in the south-eastern parts of the mainland to invest a total of 150 billion yuan ($23 billion) offshore via banks in nearby Hong Kong and Macau. Residents in the two special administrative regions can invest up to the same amount in the other direction.

While China and Hong Kong have similar pipes in place for two-way capital flows into stocks and bonds, this new arrangement is different: It only applies to investors and intermediaries in the so-called Greater Bay Area, which includes Shenzhen and eight other cities in Guangdong province in addition to Hong Kong and Macau. With a population of 70 million and a combined gross domestic product in excess of $1.6 trillion, the seamless economic zone will be among the biggest in the world.

Pushing e-CNY for asset purchases in this affluent region could be a perfect testing ground. What will it take for wealthy investors to consider Chinese taxpayer-backed digital tokens as a safe store of value? Will the new currency need to pay interest? How much? Without dismantling broader capital controls, and risking financial stability to uncontrolled inflows or outflows, Beijing can find the answers.

A successful pilot will help bolster global investor confidence in e-CNY, and may even provide a template for other electronic currencies such as the FedCoin, BritCoin, or the digital euro.

The biggest clue that China is thinking of running such a trial came recently from Xing Yujing, director of the PBOC's Shenzhen branch. In an interview with Liaowang Magazine, Xing proposed conducting a test of oversight of cross-border financial flows between Shenzhen and Hong Kong, using the digital yuan as a carrier.

The rationale behind pairing Shenzhen with Hong Kong goes beyond their geographical proximity and historical linkages. Shenzhen's economy is led by the private sector. Its cross-border flows, which are mostly with Hong Kong anyway, are 7 per cent of China's total. Any speculative spillovers can be easily contained. Shenzhen's special economic zone status, which propelled its rise as a global manufacturing powerhouse, can also be more readily tweaked than mainland laws to include a single rulebook: A bank that's allowed to do something in Hong Kong can conduct the same activity in Shenzhen, and vice versa.

Xing didn't explicitly mention Wealth Management Connect as the "financial innovation highway" she outlined in her interview. But using the e-CNY as the carrier currency for a pilot that's not limited to specific products but encompasses an entire platform does make wealth management a strong candidate.

So far, e-CNY trials have focused on its role in facilitating everyday transactions where Alipay and WeChat Pay dominate. Wary of the sway of tech titans on Chinese consumers' behaviour, the state wants to reassert control. Beijing can use the coercive power of laws and regulations to ensure the currency's success as a means of payment.

But money must also function as a unit of account and a store of value. Challenging the dollar in trade invoicing won't be easy. The Chinese currency's market share in global payments is less than 2 per cent, compared with 40 per cent for the dollar. It should, however, be feasible to encourage foreigners to keep more of their wealth in yuan.

Beijing's previous attempt at establishing the yuan as a store of value saw Hong Kong bank deposits denominated in the currency jump nearly 10-fold in five years to almost 1 trillion yuan in July 2015. Then came a shock devaluation, and half the deposits vanished over the next couple of years. The project of internationalizing the yuan stalled. Now, however, confidence has returned.

China's foreign-exchange reserves are at a five-year-high, and the yuan ended last month close to its strongest since 2018. Allowing the rich to shift some capital out may ease the pressure on the currency to appreciate. A bigger role for market forces will persuade global investors that their returns won't get whacked by a repeat of 2015-style government meddling. A narrowing volatility gap between the controlled onshore yuan and its more freely trading offshore version demonstrates that such confidence is beginning to take hold.

The digital yuan, which won't be ready at least until the 2022 Beijing Olympics, might have ­to join the Wealth Connect train later. That's just as well. Currently, e-CNY doesn't support smart contracts. Later versions may come embedded with self-executing software code. Automated securities settlements and interest payments should help lower transaction costs for investors.

Beijing's desire to challenge the dollar's hegemony is real. Using the wealthy to seed Hong Kong's freewheeling, open economy with digital yuan may be its best shot to move closer to that distant goal. (Bloomberg)