Paving the way for the new digital economy through CBDC

Stephen Wong, Kenny Shui February 18, 2022 06:00

Since the onset of the new pandemic, the trend towards a contactless economy has become more and more prevalent. As an international financial centre, Hong Kong needs to digitalise its financial system and infrastructure to stay competitive. Central Bank Digital Currency (CBDC) is a pioneer in digital financial infrastructure, with central banks in major economies such as China, the United States, the European Union, and Japan having already started CBDC-related research and development.

CBDC is a legal tender issued by a central bank in digital form, and can be simply understood as digital cash, combining the advantages of traditional cash and electronic payments. Unlike existing private sector e-money and cryptocurrencies such as Bitcoin, CBDC is guaranteed by a central bank, thus minimizing credit risk. CBDC also offers new features that are not available in existing payment methods, such as offline payments and programmability. Offline payments allow both payers and receivers to conduct transactions without a network, so areas without cell phone signals are no longer blind spots for electronic payments; programmability means that CBDCs can be programmed with rules for use as needed. CBDC can be designed to be used for consumer purposes only, with a set expiration date, and can be used to distribute consumption vouchers quickly and easily. CBDC is often combined with blockchain technology to ensure the anonymity of legitimate small value CBDC transactions, while tracking the path of the currency’s use to help achieve policy goals such as anti-money laundering and counter-terrorist financing.

Currently, 86% of major central banks around the world are conducting CBDC-related research. China is leading the way with its digital renminbi (e-CNY) project, which has entered the pilot phase in ten cities. As a traditional international financial centre, the Hong Kong Monetary Authority (HKMA) is not far behind, with a wholesale CBDC research project for financial institutions starting in 2017 and a retail CBDC research project for the public starting in 2021.

In the era of digital finance, CBDC will take up the role of conventional legal tender, fostering the development and enhancing the efficiency of the entire financial sector. For Hong Kong, CBDC will play an important role in cross-border capital flows, thus providing an opportunity for the city to further consolidate its status as an international finance centre.

Facilitating cross-border transactions for individuals

At present, Hong Kong and Mainland China have different versions of e-wallets (e.g. Alipay, WeChat Pay, etc.), which are not connected to each other, and residents of the two economies often face payment barriers when making cross-border transactions. Against this background, the Digital Currency Institute of the People’s Bank of China (PBOC DCI) and the HKMA are testing the use of e-CNY in Hong Kong, taking the first step to facilitate retail payments between the two economies using CBDC.

Hong Kong should explore how to fully utilize the technical features and advantages of CBDC to facilitate cross-border digital payments for residents of both economies. The HKMA may consider collaborating with the PBOC to launch a dual-currency digital wallet with built-in e-CNY and digital HKD (e-HKD) to facilitate cross-border spending and payments between the people of the two economies. The digital wallet should be equipped with a currency exchange function to facilitate exchange between e-CNY and e-HKD.

Fostering capital flow in the Greater Bay Area (GBA)

The development of CBDC is conducive to fostering capital flow in the GBA, further enhancing the connection and connectivity between the two financial markets.

Mutual market access mechanisms between the two financial markets, such as Shenzhen-Hong Kong Stock Connect, are currently adopting a closed-loop mode where investors cannot flexibly convert between different investment products. For instance, if mainland investors plan to convert their stock investments in Hong Kong into bond investments, they must first sell the stocks. Capital will then flow back to Shenzhen via the closed-loop Stock Connect before investors can buy Hong Kong bonds through other channels. Under this mechanism, not only does the cross-border capital transfer incur unnecessary cost, but also the risks of missing the best investment timing to investors.

CBDC's programmability and traceability provide a new technical solution for these mutual market access mechanisms. Rather than restricting funds to a closed-loop investment in a specific product category, e-CNY can be designed to only be used for cross-border investment in pre-approved types of Hong Kong investment products. In the long run, the use of CBDC will help open up the Shenzhen-Hong Kong Stock Connect, Bond Connect, Wealth Management Connect, and more. This will meet the needs of regulators to monitor capital flows on the one hand, and provide investors with greater investment flexibility on the other, not only attracting more investors and capital inflows to Hong Kong, but also having the potential to pool capital and enhance Hong Kong's position as an asset management centre.

Furthering Hong Kong’s position as an international foreign exchange centre

In addition, CBDC will offer new possibilities for international cross-border finance. Currently, Hong Kong is the fourth largest foreign exchange centre in the world. In the era of digital finance, Hong Kong should seize the opportunity to develop itself into an international foreign exchange centre for CBDC.

Currently, the PBOC DCI has joined the mBridge project led by the HKMA and the Bank of Thailand to explore the transactions and conversion of different CBDCs on this platform. It is worth mentioning that the Monetary Authority of Singapore is also working with central banks in Australia, Malaysia, and South Africa on a similar international CBDC cross-border network, striving to become the regional CBDC hub.

In the face of competition, Hong Kong should seize the opportunity and the unique advantages of having the PBOC’s participation in the mBridge project, and actively connect wholesale HKD CBDC with other CBDCs. In the long run, this financial infrastructure will also facilitate the cross-border transaction of e-CNY, thus promoting the internationalisation of the RMB, and consolidating Hong Kong's position as an offshore RMB centre.

The transition towards a highly digital economy is an inevitable trend. Hong Kong should thus seize this opportunity to pave the way for the new digital economy through CBDC.

Judy Chen, Researcher, Our Hong Kong Foundation also contributed to the article.
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Stephen Wong, Kenny Shui

Stephen Wong, Senior Vice President and Executive Director of Public Policy Institute, Our Hong Kong Foundation. Kenny Shui, Assistant Research Director, Our Hong Kong Foundation