China's eight centuries of experiment with paper money is coming to a close

The Chinese were first with the great transition from commodity money to paper money. They had the necessary technologies (you can’t have paper money without paper and you can’t do it at scale without printing) and, more importantly, they had the bureaucracy. In 1260, the new Emporer Kublai Khan  determined that it was a burden on commerce and drag on taxation to have all sorts of currencies in use, ranging from copper coins to iron bars, to pearls to salt to gold and silver, so he decided to implement a new currency. The Khan decided to replace metal, commodities, precious jewels and specie with a paper currency. A paper currency! Imagine how crazy that must have sounded! Replacing actual stuff with apparently worthless paper! It’ll never work!

Crazy or not, it worked and just as Marco Polo and other medieval travellers returned along the Silk Road breathless with astonishing tales of paper money, so modern commentators (e.g., me) are tumbling off of flights from Shanghai with equally astonishing tales of a land of mobile payments, where paper money is vanishing and consumers pay for everything with smartphones. China is well on the way to becoming a cashless society, with the end of paper money in sight. Something like one-seventh of China’s population relies on mobile payments to get around, carrying no cash, according to a survey conducted by Renmin University of China. The natural step from there is to create digital currency so that settlement is in central bank money and there are no credit risks.

This thinking has been evolving for some time. Back in 2016, the Governor of the People’s Bank of China (PBOC), Zhou Xiaochuan, set out the Bank's thinking about digital currency, saying that it is an irresistible trend that paper money will be replaced by new products and new technologies. He went on to say that as a legal tender, digital currency should be controlled by the central bank and after noting that he thought it would take a decade or so for digital currency to completely replace cash in China, he went to state clearly that the bank was working out “how to gradually phase out paper money”. Rather than simply let the cashless society happen, which may not led to the optimum implementation for society, they were developing a plan for a cashless society.

As I have written before, I don’t think a “cashless society” means a society in which notes and coins are outlawed, but a society in which they are irrelevant. Under this definition the PBOC could easily achieve this goal for China. But should they do this? Yao Qian, from the PBOC technology department wrote on the subject in 2017, saying that to “offset the shock” to commercial banks that would come from introducing an independent digital currency system (and to protect the investment made by commercial banks on infrastructure), it would be possible to “incorporate digital currency wallet attributes into the existing commercial bank account system" so that electronic currency and digital currency are managed under the same account.

This rationale is clear and, well, rational. The Chinese central bank wants the efficiencies that come from having a digital currency but also understands the implications of removing the exorbitant privilege of money creation from the commercial banks. If the commercial banks cannot create money by creating credit, then they can only provide loans from their deposits. Imagine if Bitcoin were the only currency in the world: I’d still need to borrow a few of them to buy a new car, but since Barclays can’t create Bitcoins they can only lend me Bitcoins that they have taken in deposit from other people. Fair enough. But here, as in so many other things, China is a window into the future, because Alipay, WeChat Wallet and other Chinese third party payment platforms use financial incentives to encourage users to take money out of their bank accounts and store it on their platforms. If commercial banks cannot fund loans from deposits, we are in a new place, economically speaking.

Thus you can see the potential problem with digital currency created by the central bank, even if it is now technologically feasible for them to do so. If commercial banks lose both deposits and the privilege of creating money, then their functionality and role in the economy is much reduced. Whether you think that is a good idea or not, you can see that it’s a big step to take. Hence the PBOC position, reinforced at the beginning of this year by Fan Yifei, Deputy Governor of the People’s Bank of China writing that the PBOC digital currency should adopt a “double-tier delivery system”.

Following this line of thinking, then, the PBOC is saying that it is not going to issue cryptocurrency and that it is not going to issue digital currency either (at least in the foreseeable future). But what they might do is to allow commercial banks to distribute digital currency under central bank control (this what they mean by “double tier”. You could have the central bank provide commercial banks with some sort of tamper-resistant smart chip or cryptographic permission that would create digital commercial bank money under the control of the central bank. (This, by the way, is exactly what was attempted a generation ago with the Mondex electronic cash system.)

(Note that this is entirely removed from the issue of whether to use shared ledger technology to manage the money in circulation. I’m open minded about this. I can certainly see how a system in which POS terminals were nodes in a shared ledger, thus obviating the need for a central system — that could, and does, go down — might be rather attractive but whether the resilience would be worth the expense of moving away from current solutions remains to be established.)

Not also that there is no implication in any of the PBOC’s comments that they will be issuing digital cash. Would any central bank go for this? Some form of digital cash that can be passed directly from person to person like Bitcoin rather than some form of digital money like M-PESA, using hardware rather than proof-of-work to prevent double spending? Well… yes. In fact the Uruguayan central bank has said it will test precisely this approach, having digital cash in the mobile phones pass person-to-person directly between the devices. This is not, I am sure, what the PBOC has in mind. On the contrary, the want to see every transaction, and consistent position adumbrated by last year’s decision to make mobile payment companies route transactions through a central switch.

I’m fascinated by China’s long experiment with paper money and its imminent conclusion. Whatever you might think about their position on monitoring transactions, the PBOC has been strategic in its thinking.  Their comments on the topic from 2016, 2017 and now 2018 have been consistent. Digital currency is coming and China will take the lead just as it did with paper currency.