The Chinese digital Yuan is a Central Bank Digital Currency that is undergoing testing right now. While it may seem like it will overtake the current reserve currency - the US Dollar due to its superior technology, I don’t think it will be the case.
Here’s why
Milkshake theory
A long time ago McDonald’s was trying to improve milkshake sales. They went and interviewed people if they wanted bigger milkshakes, or more flavours and so on. But even after improving the milkshakes in the way the customers wanted, they didn’t really buy anymore milkshakes.
A McDonald’s milkshake for reference
The problem was not that the milkshakes were not too big or had too few flavors. It was that they were focusing on the wrong aspect of things. People wanted milkshakes to get a job to be done. They had a long drive to work, and wanted something to keep them engaged while they drove. They needed something they could hold in their right hand and drive at the same time. And it shouldn’t be so easy to drink that they finish before they got to work.
Customers didn’t care about the ingredients of the milkshake and they didn’t really care about the flavor beyond a certain point. And most importantly they were not competing with other brands of milkshakes, they were competing with bananas, bagels and donuts. The milkshake had a job to be done: keep the customer engaged and full on the way to work.
That’s what McDonald’s did not understand about their customers, and that’s what Clay Christenson got right. People don’t buy products for the sake of buying them. They buy them because they serve a purpose.
And that is the same mistake made by people who assume that the dollar will be displaced by the Chinese digital yuan.
What Job Does the Dollar do?
For most people the dollar serves two major purposes:
It is a medium of exchange
It is a store of value
Get money across
If you’re a Brazilian company buying from an Indian exporter, neither of you wants the other person’s currencies. The Indian exporter can’t do much with the Brazilian Real, and the Brazilian company can't find Indian rupees that easily.
To make life simpler for both of them, they use the US Dollar. Due to the USA's dominance in trade, the USD is accepted widely across the world from North Korea to Venezuela. So, people use the USD a lot because they know that everyone else will accept it too. That’s why 80% of global trade is denominated in USD
It's a lot like knowing a language. People learn English because they know that a lot of other people will know it too. So, the number of people knowing English increases which then means that other people also want to learn English. In the same way, the US Dollar already has an advantage of being the most accepted currency in the world, so it's very hard for the Chinese Yuan to displace the US Dollar when there’s no incentive to switch.
It wouldn’t make a difference outside China!
Central Bank digital currencies are a lot closer to cash than they are to bank deposits. When you own cash, it's with you. But when you have a bank deposit, it's with someone else. The deposit is just a promise for the bank to give it to you when you want it. In the unlikely event that the bank fails, you don’t usually get your money back. A digital yuan would be like cash where the money is with you, and not the liability of a bank. The record of you owning it would be stored in a database at the central bank. In this case it’s the People’s Bank of China.
At the moment at least, the PBOC will be supporting records for Chinese residents only. The US Dollar’s acceptance won’t change abroad even if it becomes easy for residents abroad to use the digital Yuan.
And even if its outside China, all the money’s stuck inside
Even if we assume that the Yuan is available abroad, it still will not be able to replace the other large source of demand for the USD: a store of value.
A lot of people buy US Dollars.
Foreign central banks buy US Dollars because they need them to support their currency in case of sudden depreciations.
Foreign banks buy it because they lend in USD and many run foreign exchange departments.
Large companies typically have bills due in the US Dollars and so they keep some USD in store.
All of this adds up to some substantial demand for US dollars. Every single one of these agents wants to buy US dollars and USD denominated assets like US Treasury bills, and bonds of American companies. But if you want to put your money in a currency, you have to be sure you can take it out too.
The US has no restrictions on capitals or what is also called “capital account convertibility”. So people are confident that their USD and USD assets can be sold for their domestic currency so they can use it.
On the other hand, China does not have this. It has restrictions on moving capital out of the country for a variety of reasons making it difficult for free flow of capital in and out of China. Capital controls can be defended and in cases like China, they can be a good idea. But you can’t have both capital controls and a reserve asset because people aren’t going to invest in your country as much if they can’t take it out when they need to.
The digital Yuan doesn’t fill in any of the Jobs To Be Done of the Dollar. Just like the McDonald’s executives made a mistake by not realizing what actual function their milkshakes performed, people predicting the end of the dollar’s dominance aren’t looking at the jobs the dollar fills in.
So where can the Yuan be used anyway?
One of the biggest problems with the current dollar denominated system is that the US government can cut your access off at any time. Then you won’t be able to transact with US banks, and even some foriegn banks which want access to the American dollar payments system won’t be able to do business with you. Just ask Hong Kong Chief Executive Carrie Lam who has to keep ‘piles of cash’ at home because the US sanctioned her and no banks are willing to offer her a bank account.
For people like these and countries that have been cut off from the US financial system like North Korea, Iran and Syria, the alternative Chinese standard would be a blessing. Even if all the caveats I have mentioned apply, some payment system for them is better than no system at all.
But the Chinese government is not immune from cutting out people it does not like. It has sanctioned members of the European Parliament and European academics because they spoke out on human rights abuses in Xinjiang. They have sanctioned people for offenses far lesser than the Americans have.
So while the Chinese digital Yuan will not be the next game changer unless they open up their capital account and get more people to accept their currency, it might make an impact in countries excluded by the American system.
Your grip on the subject, focus on the matter and the flow is super cool. Way to go.
Insightful and very well articulated.