Digital disruption dollar

The world economy revolves around the US dollar. It has been the reserve currency for over 100 years. Central banks hold reserves, in currency or gold, so that they can trade and invest in other countries. A shrinking, but a still large part of those reserves is held in US dollars. Besides the United States, there are seven other countries that use the dollar as legal tender, while no less than 65 countries have their currency directly linked to the dollar. Without the US dollar, it is not so easy to buy oil, gold, toys or cars, or to invest international money in hotels and bridges. A Vietnamese company buying goods in Brazil pays in US dollars. Because everyone wants to hold dollars, the US government can borrow dollars seemingly endlessly. At the moment, the counter stands at 28 trillion dollars, 20 percent higher than a year ago. The US economy was $21 trillion last year. The total amount to date to combat the corona crisis in the United States is 5.3 trillion dollars, and that amount has not yet all been incorporated into the debt statistics. A large part of all the dollars has been created in the last twelve months. And that does not include the trillions from Biden’s infrastructure plan. This year’s US budget deficit is expected to reach 15 per cent, the largest since World War II. With the exception of Japan and the European Union, other countries do not have such a luxury to borrow whatever they want, whenever they want. If they borrow more, the price (interest) goes up.

The US dollar has this position because the United States is by far the largest economy in the world and is also a dominant player when it comes to investment and finance. But this position is changing. In 1960, the United States still made up 40 percent of the world economy, now it is 23 percent. In terms of world trade, the United States has now been overtaken by the European Union and China. The Chinese economy has grown by an average of 10.4% per year in the two decades since 1991, while the American economy grew by an average of 2.5% over the same period. China now accounts for 17% of the world economy and is likely to take over the United States’ number one position in the next few years.

This development has raised questions about the dollar as a reserve currency, as the position of a reserve currency cannot be held forever. In the past six centuries, there have been six reserve currencies, each lasting about a century. The Portuguese real was the reserve currency between 1450 and 1530. Then, due to a dispute in the Portuguese court, power passed to the Spanish, who were able to hold the position of reserve currency for 110 years. The Dutch guilder followed until the Bank of Amsterdam issued too much debt and lost the confidence of the market and investors. France followed, followed by the United Kingdom. After the First World War, the UK lost that position to the US dollar, something that was formalised in the Bretton Woods Agreement of 1944. There are several reasons why a country lost the position of reserve currency: inflation, too much debt, bad policy or simple greed.

Now, the position of the dollar as a reserve currency has been in doubt for several decades. But for a long time, there was no alternative. The euro is caught up in European politics and is a currency that seems to be only one debt crisis away from its end. The Japanese economy does not carry enough weight for the yen to act as a reserve currency, although for a long time the yen did seem to fulfil that role due to Japan’s many foreign investments. In times of stress, the Japanese withdraw their money and the yen becomes stronger. This makes it a safe haven just like the dollar. With rising Chinese economic power, the renminbi is a logical successor to the dollar. However, the problem is that the Chinese currency is not freely tradable. There are still capital controls at the border and the renminbi must first become a global currency before it can become a reserve currency. Since 2014, China has been developing a digital version of its own currency. A digital version equivalent to cash, but without the disadvantages of cash and without the need for capital controls. A digital currency is reminiscent of crypto-currencies, but the essential difference is that with digital currency, Beijing retains full control, whereas with crypto-currencies this is usually decentralised.

A digital currency issued by a central bank is usually abbreviated to CDBC (Central Bank Digital Currency). It should not be confused with cryptocurrency. Crypto-currencies are not suitable as means of payment, because of the amount of arithmetic and energy required. They may have another function, for example, many investors believe that, like gold, they retain their value and thus offer protection against unbridled monetary policy. Meanwhile, 86 percent of the world’s central banks are developing a digital currency. China is leading the way and the digital renminbi is being tested by millions of citizens in several Chinese cities. There are three reasons for developing one’s own digital currency. Digital payments are increasingly becoming the norm, especially post-Corona. This could mean that money starts circulating in networks that are out of sight of the central bank. If those networks become larger, it could threaten the control of the central bank and thus the monetary system. The second reason is the desire for financial stability. The moment one of the parties in the chain gets into trouble, the payment system is endangered and this can put pressure on the financial stability. With a CDBC, the central bank remains in control. The third reason is that a digital currency can reach anyone, even without a bank account. In many countries in Asia and Africa, a large proportion of the population still does not have a bank account and therefore still uses cash.

The disruption of digital currency lies in the fact that commercial banks will then become superfluous. With a CDBC you no longer need a bank and the technical infrastructure makes it easier for non-banks to enter. Otherwise, an increasing part of the digital payment traffic will no longer fall under the supervision of the central bank. With a CDBC, the central bank is back in control. In a digital economy, it is all about data. If companies succeed in using the digital currency to start a platform that can create positive network effects using the data, such a provider will quickly gain market share from the traditional banks. CDBCs can also take over the international payment system. Now the US sometimes uses the US dollar as a weapon by cutting countries off from the Swift payment system. A digital currency can provide a solution without Swift (and US government control). The extent to which a CDBC, such as the digital renminbi, is accepted by the general public and in international transactions. Then a CDBC can play a role in further innovation and the disruption of the financial system.

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