China Is Forcing Adoption Of The eCNY. Inflation And Asset Bubbles Are Sure To Follow

The Digital Yuan Has Already Shown Itself To Be "Bad" Money

China is starting to pay its army of bureaucrats in the digital version of the yuan,also known as the eCNY. This is very likely a bad move which will backfire on Beijing bigly.

Dr Shi added that e-CNY could also be used as "a tool to precisely implement national economic policies" and influence consumer spending.

"Let's say the central bank sees you have 100,000 e-CNY saved in your wallet for a while. Then they are capable of feeding you advertisements on a regular basis," he said.

"Maybe they will encourage you to buy a car, or let you know about good deals."

Bureaucrats being the feckless souls they are, we may safely assume that the Beijing bureaucracy will, in short order, do exactly that. Therein lies a fatal flaw of a CBDC.

To understand why this capacity of the bureaucracy to encourage or even mandate spending is self destructive and inflationary, we must recall Milton Friedman's analysis of the monetary dynamics of inflation¹.

Given that people are so stubborn about the amount they hold in the form of money, let us suppose that, for whatever reasons, the amount of money in a community is higher than people want to hold at the level of prices then prevailing. It does not for our purposes matter why, whether because the Government has printed money to finance expenditures or because somebody has discovered a new gold mine, or because banks have discovered how to create deposits. For whatever reason, people find that although on the average they would like to hold, let us say, the 7 weeks’ income that they hold in India, they are actually holding, say, 8 weeks’ income. What will happen? Here again it is essential to distinguish between what happens to the individual and what happens to the community. Each individual separately thinks he can get rid of his money and he is right. He can go out and spend it and thereby reduce his cash balances. But for the community as a whole the belief that cash balances can be reduced is an optical illusion. The only reason I
can reduce my cash balances in nominal terms is because somebody else is willing to increase his. One man’s expenditures are another man’s receipts. People as a whole cannot spend more than they as a whole receive. In consequence, if everybody in the community tries to cut the nominal amount of his cash balances, they will on the average be frustrated. The amount of nominal balances is fixed by the nominal quantity of money in existence and no game of musical chairs can change it. But people can and will try to reduce their cash balances and the process of trying will have important effects. In the process of trying to spend more than they are receiving, people will bid up the prices of all sorts of goods and services. Nominal incomes will rise and real cash balances will indeed be reduced, even though nominal balances, the number of rupees, are not affected. The rise in prices and incomes will bring cash balances from 8 weeks’ income to 7 weeks’ income. People will succeed in achieving their objective, but by raising prices and incomes rather than by reducing nominal balances. In the process, prices will have risen by about an eighth. This in a nutshell and somewhat over-simplified is the process where by changes in the stock of money exert their influence on the price level. It is over-simplified because there is a tendency to over-shoot, followed by successive readjustments converging on the final position, but this complication does not affect the essence of the adjustment process.

In Friedman’s eyes, inflation occurs when people are holding more currency than they desire, and are motivated to spend the excess, thus bidding up prices.

In the scenarios within India which Friedman described, money supply growth was the driving force of the imbalance. However, what is relevant is that there is a perceived excess, not how that excess comes to be. When people have more currency on hand than they wish, their one sure means of resolution is to spend it. By thus forcing currency to circulate more and more through an economy, without a means to withdraw this perceived excess from the economy, the only other means to restore price equilibrium is for prices to rise.

That the government in China is sure to leverage the eCNY to micromanage spending habits of the Chinese people can only incent individuals to hold as little currency as possible. There is no benefit to holding a currency only to be told next week the currency must be spent. There is no benefit to holding a currency as savings when it might be snatched back at any time—a far more sustainable saving strategy would be to purchase durable assets which can act as a store of value—land, precious metals, gems, and similar commodities. Even stock shares would be a better savings vehicle under such a currency regime than currency or any banking deposit of currency.

In every conceivable scenario, the average Chinese worker will be highly disincented to hold eCNY digital currency for very long.

This does not imply the spending will be frivolous, only that there will be more of it. With Beijing coercive pushing eCNY, the likely quantity of eCNY will trend toward zero, with money velocity and inflation heading toward a maximum.

This also in keeping with Gresham's Law, and the inevitable outcome that CBDCs must end up as “bad” money.

For The Love Of Money: Why CBDCs Must Fail

A currency which is better spent than held is the essence of “bad” money.

Thus forced adoption of the eCNY will have as a likely consequence increased spending and money velocity, which can only result in inflation and, ultimately, asset bubbles.

One reason to doubt Chinese enthusiasm for the eCNY project is the subtle liberties the propaganda is taking with the tallies of transactions using the eCNY.

Official data shows that, as of August 2022, more than 5.6 million shops accept e-CNY as a payment option, and more than 360 million transactions with a total value of 100 billion yuan ($22.2 billion) have already been made.

The 100-billion figure is a claimed total from the PBOC, which they made on social media within China last year.

As of August 31, 2022, the pilot areas of 15 provinces (cities) have accumulated 360 million transactions with an amount of 100.04 billion yuan, and the number of merchant stores that support digital RMB exceeds 5.6 million.

However, on August 31, 2022, the yuan traded 6.91295 yuan to the dollar. That puts the dollar value of the yuan transactions at around $14.49 Billion, not $22.2 Billion. For 100.2 Billion CNY to be worth 22.2 Billion USD, the exchange rate would have to fall to 4.504504 yuan to the dollar—an exchange rate the yuan has not enjoyed in decades.

Even more telling, however, is the fact that the PBOC reported some 87.565 billion yuan worth of eCNY transactions in January of last year.

Zou Lan said that as of December 31, 2021, there have been more than 8.0851 million digital renminbi pilot scenarios, a total of 261 million personal wallets have been opened, and the transaction amount is 87.565 billion yuan.

If we use the August 31 value of the yuan, 87.565 billion yuan is $12.67 Billion.

If we use the January 18, 2022 value of 6.34903 yuan to the dollar, the numbers improve slightly for the eCNY, with 87.565 billion yuan being equal to $13.8 Billion.

At either valuation, however, in the seven months from January to August of 2022, there were only 12.635 Billion yuan. Given the overall size of the Chinese economy—$17,734,062.65 in 2021—12.635 Billion yuan is not anywhere near a substantial volume of transactions.

Additionally, if we explore some of the reasons Nigeria’s CBDC, the eNaira, has largely failed to win the hearts and minds and wallets of the Nigerian people, we can find some themes that have some particular resonance with China’s recent currency laws.

Perhaps the most notable commonality is the country-level bans on cryptocurrencies. While Nigeria ranked sixth in cryptocurrency adoption, according to the 2021 Global Crypto Adoption Index, in February the country banned crypto currency all together.

This is despite the country's central bank saying in February 2021 that the use of cryptocurrencies is "a direct contravention of existing law" and banning commercial banks from dealing in them. It warned that cryptocurrency trading poses risks including investment loss, money laundering and and terrorism financing.

Similarly, China banned cryptocurrencies in September of 2021.

China's central bank vowed on Friday to crack down on illegal activities of cryptocurrency trading, banning overseas exchanges from providing services to mainland investors via Internet.

Despite the ban, Chinese users accounted for as much as 8% of failed crypto exchange FTX at the time of its collapse in November of 2022.

“Essentially, bans don’t work,” said Caroline Malcolm, global head of public policy at Chainalysis, which specializes in tracking digital-asset transactions. “The decentralized nature of cryptocurrencies and the fact that they can be transferred peer-to-peer and traded on global exchanges make it difficult for any government to completely eliminate them.”

US bankruptcy filings for FTX, which collapsed in November last year, show Chinese users accounted for 8% of the exchange’s customers. FTX advisers have tallied more than 9 million customer accounts overall, while claims from creditors amount to at least $11.6 billion.

In addition to having to overcome inherent preferences for the traditional yuan currency (or the naira currency in Nigeria), CBDCs in both China and Nigeria have to overcome a preference for using digital and crypto currencies other than the CBDC.

These hurdles go a long way to explaining the extremely slow adoption of the digital yuan in actual transactions within the Chinese economy, as well as the efforts of the media to gloss over the anemic transaction volumes with propaganda attempting to portray the eCNY as being embraced by the wider marketplace.

In a first for a foreign institution, BNP Paribas has partnered with Bank of China (BOC) to enable their corporate customers to seamlessly transact in China’s central bank digital currency (CBDC), the French bank announced on Thursday.

“The collaboration has once again demonstrated our commitment to the China market,” said BNP Paribas China chief executive CG Lai. “We will continue to enhance our customer service capabilities through digital innovation and contribute to China’s economic development.”

One has to delve a bit deeper into the same reporting to see the disclosure that there is only 13 billion yuan worth of eCNY in circulation.

China continues to lead the world in integrating its CBDC into its financial system. At the end of 2022, China’s central bank revealed that the total amount of digital yuan in circulation had surpassed 13.61 billion yuan ($2 billion), a major milestone which nonetheless represents only 0.13% of the 10.5 trillion yuan in circulation.

With 100 billion yuan of transactions being supported by only 13.61 billion yuan of digital currency, China is currently experiencing a money velocity for the eCNY of 7.36.

By comparison, with China’s GDP at the end of 2022 standing at 121 Trillion yuan, and their M2 money supply standing at 266.43 Trillion yuan, China’s M2 money velocity is only 0.45.

Remember Gresham’s Law²:

People will choose to use bad money first and hold onto good money.

The extreme money velocity of the eCNY suggests that people who use the eCNY are spending the eCNY quickly, and holding traditional yuan instead—they are defining the eCNY as “bad money”.

If this perception of the eCNY persists, and in particular if the money velocity of the eCNY persists—and even if the money velocity should fall by half as adoption increases—the greater money velocity relative to the current M2 money velocity can only result in a significant upsurge in inflation.

We only have to look to the experience of the United States and its recent bout of near-hyperinflation for confirmation of this: as inflation has taken hold in the US economy the M2 money velocity, after crashing in 2020 amid the government-ordered recession—has been increasing significantly.

With China’s current annual inflation rate at a near-comatose 0.1%, a surge in money velocity of any kind could easily produce inflation at or above what the US is experiencing today.

Again hearkening back to Friedman’s thesis on inflation as a monetary phenomenon, money velocity is an essential driving variable as to how high inflation can become³.

The tendency for changes in velocity to reinforce changes in the money supply on some occasions and to counter-act them on others has two very important implications. The first is that in an inflation whose prevalence is becoming widely recognised the effect of a change in the stock of money on prices may be a multiple of the change in the stock of money. The second is that, while inflation or, in the contrary case, deflation is produced by changes in the stock of money per unit of output, the relationship is not mechanically precise. It is not always the same under all circumstances and it cannot be predicted with precise accuracy.

While we cannot predict either how great China’s overall eCNY money velocity will be, or what its final contribution to M2 money velocity will be, we can be certain that, based on the data, expanded use of the eCNY is highly likely to increase money velocity and, as a consequence, is highly likely to increase inflation—a problem China has not in any degree had since right before the lunatic lockdowns in early 2020.

While the US efforts to get its economy back on track following the 2020 lockdowns has resulted in stagflation, China is currently flirting with deflation.

It is entirely conceivable that Beijing would at first embrace resurgent inflation, as that would seem an improvement over the deflation currently stalking the Chinese economy. However, Beijing would quickly run out of ways to absorb the increased money velocity resulting from broader (and coerced) use of the eCNY. If that should prove to be the case, renewed asset bubbles throughout the Chinese economy quickly become not just a probability but an absolute certainty.

The more the state apparatus pushes the eCNY through mechanisms such as government payrolls, the more likely it is that eCNY money velocity will remain high—people already are telegraphing a reluctance to hold the eCNY, thus there is no reason to presume they will not continue to look for ways to spend it, either in conspicuous consumption or in asset accumulations (or both). In either case, the higher money velocity means that prices are going to rise rapidly, both for consumer goods and for durable assets capable of retaining value.

This is not an economic scenario that is likely to make the yuan attractive to anyone, either within China or without. This is the economic scenario that is likely to emerge, based on the data China has published about eCNY usage thus far.

1. Friedman, M. “Inflation: Causes and Consequences. First Lecture.” Dollars and Deficits, Prentice Hall, 1968, pp. 21–46. Retrieved online from https://miltonfriedman.hoover.org/internal/media/dispatcher/271018/full

2. The Investopedia Team. “Gresham’s Law: Definition, Effects, and Examples”, Investopedia. 8 Feb. 2023, https://www.investopedia.com/terms/g/greshams-law.asp.

3. Friedman, M. “Inflation: Causes and Consequences. First Lecture.” Dollars and Deficits, Prentice Hall, 1968, pp. 21–46. Retrieved online from https://miltonfriedman.hoover.org/internal/media/dispatcher/271018/full