Oct 16, 2019 10:15 AM | James Gong

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It is, perhaps, one of the most striking ironies of our time. Cryptocurrencies, invented with the explicit goal of decentralizing finance, have become popular enough that China’s Central Bank is planning to make its own version of a crypto token (albeit not a decentralized one). 


China’s goal isn’t to make its new crypto a store of value like Bitcoin, or “digital oil” like Ethereum. Instead, it’s aiming to do something that’s perhaps even more ambitious: replace cash.


How, exactly, could that work? Before we dig into China’s plans, it may be instructive to review what happened when India eliminated several bank notes rather suddenly a few years ago.


India Eliminates Bank Notes


On November 8, 2016, India’s Prime Minister Narendra Modi delivered a speech on TV announcing that 500 and 1000 rupee banknotes would be demonetized and replaced by new notes. Indians had 50 days to exchange their cash; after that, the old cash would be unusable.


The government said this action was intended to fight terrorist financing and money laundering as well as to mitigate corruption, drug dealing and smuggling. (In India, many people choose to keep large-denomination banknotes at home instead of in banks. Some of those deposits are legal income, but gray money and bribe money can also be hidden this way.)


Before Modi’s announcement, Indian authorities had called on people to be honest about their income, and even customized an amnesty act for tax evaders, saying those who came clean on taxes and paid another 45% levy would be exempt from criminal charges. However, this appeal was mostly ignored. And a few years later, the data suggest that Modi’s ploy to fight corruption through the sudden banknote devaluation has mostly failed.


China Aiming to Replace Cash with Crypto?


Now, it looks like China aims to replace banknotes too, although not nearly so suddenly. The People’s Bank of China has allegedly neared completion of its own cryptocurrency (DCEP). In the statement published by the central bank, this planned Digital Currency Electronic Payment system (DCEP) will be a two-tiered system and offer a banknote-to-DCEP exchange services at industrial banks. 


An important point is that know-your-customer procedures will only be required for those attempting to trade in large sums of cash. For those who’d like to trade small amounts of cash for this new digital currency, there will be no need to register personal information.


Mu Changchun, the head of PBoC’s Digital Currency Research Institute, has also said that users won’t need to go through commercial banks to use this new currency. They can just download the app and register an account, then use the wallet to receive money. 


“If you want to exchange for some digital currencies, you can use your bank card to swap,” Mu has said. 


“Considering anti-money laundering, we will set caps for wallet usage at different levels. For example, if you have registered a wallet with a mobile phone number, then you can use your wallet at the lowest level, which will only allow small payments for daily life. But if you upload your ID card or further bind a bank card, you can upgrade your wallet to a higher level. There may be no restrictions at all if you register your digital wallet in person at a bank.”


Many people have been wondering why the Chinese central bank is so eager to release the DCEP. Some believe that the DCEP is for accelerating the internationalization of the renminbi, but this makes little sense — as long as the exchange between currencies faces limitations, RMB internationalization will meet difficulties. Generally, no institutions will choose a currency whose exchange condition is dictated by its government. 


Mu has highlighted that the DCEP can be used without connecting to the network, and deemed it legal for paying off public or individual debts. So is this a plan to replace cash? That’s what Chinese officials are saying. On September 24, Yi Gang, the governor of PBoC, noted at a press conference that “the goal is to replace [...] a part of cash.”


There’s no denying that the DCEP looks positioned to tackle some of the same issues Modi’s banknote devaluation was aimed at. Once the central bank’s digital currency comes into the mainstream, illegal or underground cash dealers could be eliminated. A banknote devaluation like India’s would eliminate hidden stacks of cash from crime and corruption overnight.


Of course, there are also tax implications. Tax evasion would become extremely difficult, since all movements of digital funds are transparent to the government. Cash income that was previously off the books would be completely integrated into the tax system. Moreover, freezing anyone's cash account directly, which is not feasible now, could be easily achieved in the future.


The government could also add an exchange cap for large sums of digital currency, and seize, freeze, or devalue large sums of the digital currency if their owner couldn’t explain how they earned the money. 


Did It Work In India?


The original intention of India’s action on abolishing the large-denomination banknote is to tackle tax evasion, corruption, rent-seeking, and the underground economy. But last year the New York Times reported that according to figures from the Reserve Bank of India, 99% of the value of the old bills that were removed from circulation later went back into the financial system. “The figures suggested that criminals and other hoarders, like nearly everyone else, found ways to change their old bills for new ones.”


In other words, almost all of the discarded banknotes have been replaced with new banknotes. This is far from the hoped-for effect in economic and financial governance promised by the Modi government. It may even have served as a money laundering scheme for criminals who exchanged ill-gotten old bills for the officially-sanctioned new ones.


Looking at the result of India’s attempt, the demonetization was apparently a failure. It didn’t have the anti-corruption effect it was ostensibly intended to produce. 


However, according to Indian Finance Minister Arun Jaitley,the demonetization was not aimed at confiscating criminal funds. Rather, it was meant to bring the shadow economy back into the mainstream economy. The banknote replacement branded as an “anti-corruption” action was really a method of strengthening financial control and social taxation.


The demonetization’s anti-corruption branding and the fact that it caused some trouble for the rich made it palatable to common people, but the interests of the rich were barely affected and some even benefitted. 


The failure of India can be largely blamed on the cash-oriented nature of its society at that time. Few people used electronic payments, and a large number of technical issues occurred during the exchange period that caused problems. 


In retrospect, having a largely cashless society may be necessary for such a radical action to work. If that’s the case, China is the right country to try it, considering that it has arguably the most developed e-payment culture in the world.


The People's Bank of China should also learn from the failure of India's demonetization, and avoid extreme measures and technical issues. But it should face an easier challenge than Modi’s government did due to the proliferation of smartphones and the familiarity with e-payment systems already in place in China.


Of course, there’s another advantage to the system from the government’s perspective. Banknotes are the central bank’s debts, which means that the central bank can take advantage of DCEP to abolish parts of these debts. Given the severe inflation faced by the Chinese central bank, eliminating some of the outstanding cash by replacing it with a digital currency seems ideal. And since it should only harm those who can’t convert their ill-gotten cash hoards into digital currency, opponents will have a tough time arguing it shouldn’t happen.


Judging from the technical details of DCEP unveiled so far, it is unlikely to have any relationship with the blockchain, let alone Bitcoin or any other cryptocurrencies. That said, if the central bank is ready to reveal more and ultimate demonetize cash, there will likely be early birds taking actions to secure their stashed money by buying cryptocurrencies, or further converting their cash into US dollars and other fiats via cryptocurrencies. Thus, while it isn’t likely to affect crypto in the long run, the DCEP and cash-replacement could be bullish for crypto in the short-term.


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