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Carrie Lam’s Problem—and Ours: China’s State-Backed Digital Currency

The feverish rise in the trading value of digital currencies in the last twelve months suggests that they are in the advanced throes of a faddish and complicated reenactment of the typical investment bub­ble. Yet to dismiss the whole phenomenon would be a mistake. At some point over the next year, a groundbreaking digital currency launched by China’s central bank is likely to create a parallel pay­ments network—one beyond American oversight—thereby crippling U.S. sanctions policy. This devel­opment will compromise U.S. power around the world, and therefore should attract interest from more than the usual suspects who obsess over digital currencies.

To understand what China is trying to do, consider Carrie Lam’s current problem. Hong Kong’s chief executive recently disclosed that she has been receiving her HK$5.2 million ($672,000) salary in “piles of cash” stacked at her house as a result of U.S. sanctions. Amazingly, Lam no longer has access to credit cards or even a bank account. As the chief executive of Asia’s largest financial center, this probably feels cruel and unusual. Even El Chapo had access to debit cards.

Lam’s dilemma is a symbol of the extent to which U.S. power is now more reliant on the centrality of its financial system than on the two U.S. fleets in the Pacific Ocean, or the hundreds of U.S. combat drones in the sky. Because even state-owned Chinese banks use inter­bank payments and correspondent banking networks (collectively known as swift), in which the U.S. dollar is central, they ultimately have to comply with U.S. sanctions. If they do not, the American Treasury can withhold those institutions’ access to dollars, ending their ability to service large Chinese clients in cross-border transactions. That alone would spell the end of international business, both for corporations as well as for individuals. Even Belt and Road loans from China to developing countries are typically made in dollars.

This is the least of Lam’s troubles, however. Without a bank account or debit cards, Lam cannot even subscribe to Netflix or Spotify or pay for a PlayStation account. And yet, her impasse is being solved. China’s central bank has been working on its own digital currency, a so-called e-renminbi, since 2014. China is now rolling it out in some provinces, and about half a billion dollars of transactions have been completed.

The e-renminbi will connect users to third-party payment compa­nies that are themselves plugged into a centralized ledger run by the People’s Bank of China.1 Individuals will not need a bank account to use it, but can instead use payment wallets connected to the People’s Bank of China (PBOC).2 The Chinese state will be able to see every single transaction in the system, which of course is part of the attraction.

Circumventing SWIFT

Understanding the unique attributes of China’s new digital currency requires a bit of background: Money can be broadly divided into token-based money and account-based money. Token-based money (e.g., currency notes, gold bullion) can be transferred directly from one party to another without relying on an intermediary, but account‑based money (e.g., money in a bank account) cannot be transferred directly from one party to another and instead depends on intermediaries (e.g., the banks where the accounts are held) to effect transfers. Another distinction is verification: token-based payment systems rely on the ability of the payee to verify the validity of the payment object. By contrast, systems based on account money de­pend fundamentally on the intermediaries’ ability to verify the ac­count holders’ identities. Within token-based money, there is a fur­ther distinction to make: tokenized claims (e.g., currency notes, cen­tral bank digital currency) and claimless tokens (e.g., gold bullion, private digital currencies like Bitcoins). “Tokenized claims” represent a claim on an entity or right on an underlying asset, and “claimless tokens” don’t represent any such claim or right, but are of value in and of themselves.3

The e-renminbi will be both account-based and token-based; it will be account-based between the central bank and private payments intermediaries, and token-based between those intermediaries and individuals. Unlike in private digital currencies, such as Bitcoin, that second layer will be a tokenized claim instead of a claimless token. Individuals using it will be able to make payments and hold cash out­side commercial banking accounts and without investing in liquid money market funds. This means they would also be able to operate outside institutions that are within the purview of the swift system.

Still, the e-renminbi by itself does not solve Carrie Lam’s problem unless she can use a renminbi e-wallet in mainland China into which the government of Hong Kong is willing to pay her, and even then there is a currency mismatch.4 This is where China’s second digital currency experiment comes in.

Whereas the e-renminbi applies to domestic payments, the Intha­non-LionRock project is a tool for cross-border payments. This is an ongoing pilot project by the Hong Kong Monetary Authority (HKMA) and the Bank of Thailand to implement a cross-border payments system based on distributed ledgers—the technology under­pinning cryptocurrencies like Bitcoin.

And yet there is a crucial difference: while the Bitcoin ledger is entirely decentralized and ultimately controlled by no one, this pay­ments system would have two layers, with the issuance of tokens conducted solely by the Hong Kong and Thai central banks (rather than “mined,” as with Bitcoin). Payments, however, are recorded in a decentralized manner (like Bitcoin).

Inthanon-LionRock, the first phase of which was completed in December 2019, will make payments instantaneous, simpler, cheaper, and more transparent.5 The full results of the second phase will come in the first quarter of 2021, but, essentially, the infrastructure to send funds across borders outside the current dollar-based banking system is now almost in place.

When both the domestic digital currency and cross-border proto­cols are ready, China will only need to connect them, via a specific transfer protocol. It need only replicate the Hong Kong–Thailand route with a similar Hong Kong–China route.

Carrie Lam’s dilemma will therefore almost be solved. Both Hong Kong’s government and Carrie Lam could maintain a simple e-renminbi digital wallet in China. Remitting money into and out of China could be done using the Inthanon-LionRock distributed ledger technology connecting the PBOC to the HKMA (selectively over­riding stringent Chinese capital controls, of course).

Carrie Lam would get Hong Kong dollars supplied into a simple wallet in Hong Kong connected directly to the HKMA rather than to any local bank. The United States may sanction the wallet provider, but a standalone fintech app with a link to the central bank and with­out a link into the local banking system would be relatively unaffected.6

The plan is not foolproof: the United States could still retaliate by banning the use of dollars by the PBOC and the HKMA, just like the United States has done for the Central Bank of Iran. But will it really do so in this case? Hong Kong is not Iran, to put it mildly; it is much more central to the global financial system. Banning the HKMA and PBOC’s holdings of dollars would entail, in the first instance, a forced disposal of several trillion dollars of U.S. government debt. Ultimately, there­fore, there is a good chance the United States will try to preserve the stability of its debt market and not do anything. In which case, Carrie Lam’s flat will shed its unbecomingly criminal aesthetic.

The Centrality of Finance to American Power

Clearly, the paycheck of a Hong Kong official is not the most im­portant issue at stake here. The broader question is the effect of China’s coming digital currency on U.S. sanctions policy. To put it plainly, the expansion of a Chinese digital currency will ultimately pry open the U.S. grip over global payments, and therefore compromise U.S. sanctions policy and a significant measure of U.S. power in the world. The consequences go well beyond the monetary realm.

It is not that China’s digital currency is going to become the dominant standard of payments; the Chinese government remains too untrustworthy for that and, moreover, does not permit the free flow of capital into China. But it could become one standard, creating a parallel system with which to avoid the long arm of U.S. regulation. The U.S. sanctions power is premised upon the dollar’s reach into every corner of the financial system, so a permanent leak in that system has asymmetric consequences.

Sanctions and export controls are the most powerful tools of economic leverage that the United States has. That is because they are the least tethered to the heft of U.S. economic demand and supply.7 Sanctions make full use of the centrality of U.S. finance in the global economy, while export controls deploy U.S. technological might in key supply chains. Both get into the wee cracks of the global economy. Unlike the traditional tools of economic leverage, which only affect transactions U.S. actors are a part of, these allow the United States to stop transactions to which it is not even a party.

The canonical example is French bank BNP Paribas. Despite the fact that its transactions with Iran, Sudan, and Cuba were neither illegal under French or EU law, nor violated France’s obligations under World Trade Organisation rules, nor any agreements between France and the United States, it paid a $9 billion fine. Because the deals were denominated in dollars, the deals ultimately came under U.S. regulatory authority.

BNP Paribas was welcome not to pay the fine, in which case the bank would be prohibited from dealing in dollars forever. Similarly, the United States makes it hard for China to trade with Iran. The Bank of Kunlun, China’s main lender for processing Iran-China pay­ments, was sanctioned by the U.S. Treasury in 2012; it responded by handling payments from Iran in yuan and euros instead. Yet it halted even these in 2018 under sanctions pressure, and this year has tight­ened the reins further.8

By contrast, no matter how strong China is today, it cannot stop a transaction between the United States and Mexico. When it comes to exerting pressure abroad in diplomatic and political ways, this is America’s true “exorbitant privilege”—not, as some suggest, seigniorage income, which is minuscule, or its ability to raise debt at a low cost, which is not unique (Greece raises debt at a lower nominal yield than the United States today).9

The other tools of economic leverage—tariffs, import controls, investment restrictions, and law enforcement tools—can only do damage in proportion to a country’s size. If a country shrinks relative to the global economy, its tariffs immediately hurt less; its investment restrictions are less problematic; its use of law enforcement tools are less painful. This is why U.S. restrictions on Huawei were much more destabilizing for that company than the Australian restrictions im­posed in 2012.

Moreover, those tools decline in potency as U.S. power declines. And is not the central geopolitical fact of the twenty-first century that America’s weight in the global economy is declining every year? Today the United States generates a fourth of nominal global output, down from nearly a third two decades ago. In the same period, China quadrupled its share of global output to 16 percent. No feast lasts forever, and the end of this particular banquet, in which the United States remained central to every major geoeconomic development in the world, is upon us.

Yet U.S. finance has long been oblivious to the cadence of relative economic decline. Even as America’s relative global output has shrunk, its share of financial reserves has remained stubbornly high. The dollar’s share of global reserves is around 60 percent (down from 70 percent in 2000), and New York remains the world’s preeminent financial center. The demand for dollar-based assets—not just U.S. Treasuries, but also technology assets listed in the United States—remains enormous, as 2020 has shown. Enforcement of U.S. sanctions is therefore premised on the dollar’s centrality to global finance, which itself is one of the geopolitical heirlooms the United States has inherited from its unipolar moment in the late twentieth century.

We have long known that currencies and financial centers persist long after the decline of the economies that gave rise to them, due to network effects and incumbency advantages.10 But why? The crucial link to establishing financial centrality—and to maintaining it—appears to be payments. As Mark Carney, the former Bank of Eng­land governor, pointed out in his Jackson Hole Economic Symposium speech in 2019, “history shows that the rise of a reserve currency is founded on its usefulness as a medium of exchange, by reducing the costs and increasing the convenience of international payments. The additional functions of money—as a unit of account and store of wealth—come later, and reinforce the payments motive.”11

The U.S. grip on the payments system rests on there being just two ways to clear large-value U.S. dollar payments. First, through chips (the Clearing House Interbank Payments System), the U.S.-based consortium of forty-seven global banks. Second, through Fedwire, operated by the Federal Reserve. Both are ultimately controlled by the U.S. government. The U.S. government can also demand that the Belgium-based Society for Worldwide Interbank Financial Telecommunication (swift)—the world’s largest electronic payment messaging system—turn over information about transactions to the United States. America has other tools in its financial sanctions toolkit, but payments are by far the most important.12

The end of a U.S. monopoly over global payments via a Chinese digital currency would not represent the end of U.S. dollar dominance. The dollar will be the most important global currency for decades to come—just, forgive the comparison, like sterling was.

Nevertheless, all this does suggest the beginning of the end of the expansive sanctions regime that came into its own after September 11, one that was used against Russia, Venezuela, and Iran, and which then flowered under the Obama and Trump administrations. Very soon, U.S. power will have to lean much more on export controls and on the diminishing relative heft of the U.S. economy.13

What can the United States do? The historian Niall Ferguson, early in recognizing the threat of digital currencies to American power, has suggested that the United States start competing in digital payments before the “Chinese connect their digital platforms into one global system.”14 The goal should be to try to shape the emerging technology according to U.S. values and those of its allies.

Specifically, the United States could sponsor its own central bank digital currency, or it could sponsor and regulate a private one, like Bitcoin or Facebook’s Diem (formerly known as Libra), the latter backed by the dollar and other currencies. For all the skepticism heaped on Facebook’s Diem initiative, it has galvanized official U.S. thinking on the subject of digital currencies—even congressional staffers have started pontificating about it. Without the wolfish ambition of Mark Zuckerberg, the United States would be even more behind than it already is. The United States should attempt both public and private approaches and see what sticks. The broad strategy should be to preserve some kind of standard-setting power in global payments networks.

At the same time, the reality is that a disruptive new technology, one in which China has a seven-year head start, is undermining a complex system that gives the United States power over nearly every large financial transaction on the planet. That power to sanction everybody and anything, unique in great power history, was arguably never long for this world. One day it will be remembered for having burned brightly for roughly half a century to the 2020s.

Multipolarity and Its Discontents

The writer Bruno Maçães recently described his impressions after talking to young artists in Iran: “While rebelling against the confined spaces of life in Tehran, they also insisted that they did not want to follow the same path as Europeans or Americans. Contemporary art had taught them that there is always a different way of seeing. . . . Western modernity is for them just another form of tradition to be uprooted and overcome.”15 In other words, an instinctive affirmation, even a yearning, for multipolarity resonates around the globe.

The kind of world those Iranian artists believe in is almost here, but unfortunately no one has much experience with it. Since the end of the Napoleonic Wars, we have lived in either unipolar or bipolar worlds. Arguably, this was a direct result of the Westphalian order, which pitted states against each other until one or a couple effectively achieved supremacy. A world of true multipolarity—for instance the world of eighteenth-century land-based empires, in which Safavid Persia, Romanov Russia, Mughal India, Ottoman Turkey, and Qing China checked each other’s regimes across the great mass of Eurasia—is probably less familiar to foreign policy analysts than the world of the Peloponnesian Wars some two thousand years earlier.16

Indeed, the revulsion toward imperial dominance that has been orthodox in the West for over a century is probably only possible because memories do not extend back to the chaotic, violent world those expansive constructs replaced. Moreover, the bloodiest parts of an empire were usually the edges, as the peoples of the Balkans have always known. A world in which the United States can no longer impose its will using sanctions will likely be a more fluid, amoral, and inconsistent place, even more than the present day already is.

Consider policy towards apartheid South Africa. Policies like the boycott campaign the United States pursued in 1986, and which contributed to that regime’s celebrated demise, would have been impossible if a power the size of China was able to muscle in to finance alternative trade and investment patterns. (And who would doubt that the Chinese would tolerate apartheid when they have interned over a million Uighurs in camps in Xinjiang?)

Such a multipolar world, with state and private actors taking advantage of the cracks in global governance, is already coming into view. The United States is going to lose much of the sanctioning power it has enjoyed for the last several decades.

For now, techno-optimists celebrate the possibilities inherent in private digital currencies like Bitcoin, Ethereum, Ripple, and so on. (They say less about state-backed digital currencies.) This optimism about digital currencies is perhaps most fully expressed in a strange 1997 book called The Sovereign Individual, a text celebrated by many in Silicon Valley, including Peter Thiel and Balaji Srinivasan.17

The book foresaw the decline of the nation-state and the rise of cosmopolitan elites who use technology to avoid taxes and scrutiny. It predicted a backlash from the economy’s losers against the rich and well-educated, widespread secession movements, and envisaged a “new digital form of money . . . consisting of encrypted sequences, unique, anonymous, and verifiable.”

According to the optimistic reading, which deserves to be taken seriously because it is so influential, there are powerful technological currents working against the nation-state, of which private digital currencies are just one—and, crucially, this is something to celebrate for those who value individuality, human creativity, and freedom.

Twenty-four years on, we are almost inhabitants of this particular kind of paradise. The cryptocurrency Tether has on average more than $40 billion in daily transactions, greater than the sovereign currencies of Thailand or Indonesia, which collectively serve more than three hundred million people.18

Unfortunately, it is widely suspected that Tether is being used for criminal behavior. In August, the U.S. Department of Justice an­nounced that it had frozen cryptocurrency accounts belonging to al-Qaeda.

It is probably a good time to clarify who “sovereign individuals” actually are. Who in fact lives independently of his fellow citizens and thrives despite the state, while using technology to transcend the mass of lumpen fellow-travelers? The “sovereign individual” might de­scribe a successful Silicon Valley entrepreneur living apart from the great unwashed; but it may also describe a bearded man in a cave in Afghanistan with a plan to blow up a great city. Both, after all, have been known to change the world.

Yet the question that is likely to keep Janet Yellen’s Treasury staff awake at night is a more concrete one. Now that China is at the threshold of obviating U.S. sanctions policy, can America continue to keep Carrie Lam from paying for a Netflix account?

This article originally appeared in American Affairs Volume V, Number 1 (Spring 2021): 114–24.

1 More formally, the digital currency/electronic payment (DCEP).

2 Digital payment wallets exist today but the funds in them are ultimately held as investments (like Alibaba’s Yu’e Bao fund) or within accounts in the banking system.

3 See Shreepad Shukla, “Historical Context and Key Features of Digital Money Tokens,” Barclays, August 25, 2020.

4 Inconveniently, Lam’s daily expenses are in Hong Kong dollars, not renminbi; so even if she did get paid in renminbi, Lam would need a way to convert her renminbi-based income into Hong Kong dollars. Moreover the Government of Hong Kong receives tax revenues in Hong Kong dollars, not renminbi. Using the two largest e-wallets in China, Alipay and Tenpay, as intermediaries are out of the question given that Alibaba and Tencent have large U.S. financial entanglements; Alibaba’s primary listing is even in New York.

5 Currently, sending money from one currency into another is slow, expensive, and nontransparent because it involves a chain of intermediaries. Completion requires numerous back-and-forth interactions between multiple parties and full settlement takes days. The cost of sending funds internationally has stopped falling as quickly as it did in previous years because the number of banks involved in international payments has shrunk by around 25 percent since 2010 due to higher regulation. See: Tara Rice, Peter von Goetz, and Codruta Boar, “The Global Retreat of Correspondent Banks,” BIS Quarterly Review (March 2020).

6 More simply still, the Government of Hong Kong could pay her by establishing Hong Kong’s own digital currency, along the lines of the e-renminbi, and pay her directly. But for now there are no plans for a Hong Kong digital currency, probably so as not to steal the limelight from the e-renminbi.

7 Elizabeth Rosenberg, Peter Harrell, and Ashley Feng, “A New Arsenal for Competition: Coercive Economic Measures in the U.S.-China Relationship,” Center for a New American Security, April 24, 2020.

8 Chen Aizhu, S. Zhang, “Exclusive: As U.S. Sanctions Loom, China’s Bank of Kunlun to Stop Receiving Iran Payments—Sources,” Reuters, October 23, 2018. This is also why Russia has been trying so hard to pursue de-dollarization, for instance by converting its reserves out of dollars. It also reacted to U.S. sanctions after Crimea by giving Visa and MasterCard an ultimatum: become vendors to a new domestic payment system of which the state owns 100 percent, or face a total ban in which the state would build its own payments system. Both Visa and MasterCard effectively handed over their technology to stay in the market.

9 For a broader discussion on the U.S. dollar’s role in the world, see and Sahil Mahtani, “The Dollar May Be Knocked Off Its Pedestal,” Wall Street Journal, May 22, 2019, and Sahil Mahtani et al., “Dedollarisation: How a Global Currency Shift May Surprise Investors,” Ninety One Investment Institute, March 15, 2019.

10 London did not supplant Amsterdam as the world’s leading financial center until the turn of the nineteenth century (as a result of Napoleon’s 1806 Continental Blockade), despite the fact that the Netherlands had ceased to be a major player in the eighteenth century after financing the Wars of Spanish and Austrian Succession. Similarly, the U.S. economy surpassed the UK’s in size in 1872 and the entire British empire sometime between 1901 and 1913. But the dollar’s exorbitant privilege—which I measure as its share of global reserves relative to the share of the domestic U.S. economy in global output—surpassed sterling consistently only in the early 1970s. Until the British economy’s absurd and catastrophic run in the 1970s, which led to the 1976 IMF bailout, sterling’s exorbitant privilege was still the greatest in the world. See Youssef Cassis, Capitals of Capital: A History of International Financial Centres 1780–2005 (Cambridge: Cambridge University Press, 2012).

11 Mark Carney, “The Growing Challenges for Monetary Policy in the Current International Monetary and Financial System” (speech, Jackson Hole Economic Symposium, August 23, 2019), Bank for International Settlements.

12 These include barring “primary dealer” status for handling U.S. government debt securities, or blocking FX transactions in U.S. jurisdictions.

13 This can be illustrated using OFAC data. “For European Firms, Resisting American Sanctions May Be Futile,” Economist, May 19, 2018.

14 Niall Ferguson, “America’s Power Is on a Financial Knife Edge,” Boston Globe, September 15, 2019.

15 Bruno Maçães, “Memories of Tehran,” World Game, November 14, 2020.

16 Alexander Chartres, “A New World Disorder?,” Ruffer Review, February 28, 2019.

17 James Dale Davidson and William Rees-Mogg, The Sovereign Individual (New York: Simon and Schuster, 1997).

18 Tether is actually a digital representation of the U.S. dollar, which is why it is so popular. It is a U.S.-dollar-backed digital token that can be transacted in a decentralized way. In theory, each token is backed by a dollar held by the company behind Tether. Cryptocurrencies like that are particularly vulnerable to U.S. power because the banks that process those payments can be sanctioned just as the banks that do business with Iran.

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