Why the Fed needs to take the digital yuan seriously

If the Federal Reserve still wants proof of China's intention to challenge the dollar's hegemony, it should look no further than a small experiment currently under way in Hong Kong.

Last week, Bank of China (Hong Kong), one of the city's big deposit-taking institutions, had its offer of 500 trial accounts tied to the e-CNY, the electronic version of official Chinese money, snapped up in two days. The customers are each being gifted 100 yuan in digital form, which they can spend at mainland stores, the JD.com website or a supermarket chain in Hong Kong. The modest debut underscores Beijing's resolve: Even before the digital yuan could become a payment instrument of choice at home, authorities are testing its capabilities in another market.

Expect the trials to pick up speed as the e-CNY integrates with Hong Kong's so-called Faster Payment System, a 24x7 network for people to pay one another and settle bills instantaneously using mobile numbers, email addresses or QR codes. Once that link is in place, someone with a bank account in Hong Kong should be able to shop with digital yuan on Alibaba Group Holding Ltd.'s Tmall and Taobao sites without the fees involved in credit-card transactions — or the delays and uncertainty faced when paying through local bank accounts linked to the AlipayHK wallet. 

Hong Kong is just a test case. Beginning with South Korea at the start of the new millennium, more than 60 economies have come up with their own versions of smartphone-based, real-time, retail-payment systems. China might want to tie up with more of them to broaden the usage of e-CNY, but only in international settlements. (As China's special administrative region, Hong Kong is in a unique position. In general, Beijing would be careful to stay out of domestic payments, lest it's accused of encroaching upon the monetary sovereignty of other nations.)

The benefit of pushing e-yuan in trade will be that even the tiniest of mainland suppliers will be able to quote prices to foreigners in the local currency. High transaction charges on cross-border payment gateways won't get in the way. The Chinese currency's share in global payments will have a chance to move up from 2% where it's been stuck despite two decades of efforts to internationalize the yuan.

The Federal Reserve is yet to make up its mind on whether to pursue a digital dollar. Some policymakers, like Fed Governor Christopher Waller, have said that a new payment instrument may not be necessary to protect the dollar's privileged status. However, Washington should pay closer attention to how the e-CNY could potentially dislodge the US currency from regional commerce, at least in Asia and the Middle East.

A dominant medium, one that changes hands in almost 90% of all foreign-exchange transactions, won't be toppled overnight. Still, it may make sense to remember that an estimated 36% to 40% of greenback demand comes from being a good "vehicle" for indirectly exchanging two non-dollar currencies. This function has a cost. Banks charge $120 billion — nearly equivalent to the gross domestic product of Morocco — to move $23.5 trillion across borders annually, according to research by Oliver Wyman and JPMorgan Chase & Co.

A Thai importer paying under $3,000 to an Indonesian exporter must fork out $40 in fees. First, the importer's bank takes a cut for moving the funds along to a bank that will exchange the Thai baht into dollars. Those dollars then find their way to a large institution that's a member of the US correspondent banking network. The funds may have to jump again to reach another network member that has an account with a lender in Indonesia. Upon receiving instructions, this middleman will swap the dollars into Indonesian rupiah and hand them over to the payee's bank, which will pay the exporter. There are charges at every stage.

The whole chain could shrink, and costs fall dramatically, by using distributed ledger technology. That's the idea behind mBridge, a joint project of the monetary authorities of China, Hong Kong, Thailand and the United Arab Emirates. A recent pilot brought 20 of their large financial institutions together on a shared blockchain. There, they swapped prototype digital currencies issued by their central banks to settle cross-border claims of their corporate clients. Funds didn't have to move from one bank to another. The dollar didn't enter the picture. 

Correspondent banking emerged in the late 1800s, so it's natural to expect that a shift away from it will take years, if not decades. But at least the tools to cut the dollar out as a middleman in regional Asian trade are starting to emerge. 

The e-CNY serves two objectives. The more urgent goal is to fill a domestic hole. Usage of physical cash in China's economy is dwindling, as it is in Sweden and some other parts of Europe. Since a nation's money is too important to be left entirely to the private sector, authorities have come up with a digital alternative for their legal tender. However, the internationalization of the e-CNY has a different, more geopolitical, motivation. The payment instrument gives Beijing a fresh chance to realize its long-term goal of reshaping the US-centric global monetary order.

To fully grasp the upcoming challenge, Washington may have to look at how the digital yuan performs backstage, where financial claims arising from trade have to be settled. That's where real competition to the dollar may crop up. 

Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services in Asia. Previously, he worked for Reuters, the Straits Times and Bloomberg News. @andymukherjee70

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.