Thursday, January 28, 2016

Why the People's Bank of China May Consider Embracing Bitcoin

The idea of central banks owning bitcoins as a new reserve asset is no longer far-fetched. Indeed, a central bank recently published a research paper weighing the pros/cons of central banks holding bitcoins in reserve, and central banks in the UK, The Netherlands, Tunisia, Ecuador, and China have all announced they are exploring creating their own bitcoin-like digital currencies.

It has been fascinating to observe bitcoin's growth in China, which for some time now has dominated both bitcoin exchange trading and mining. Although the reasons are not immediately obvious, the People's Bank of China (PBOC) may have particularly good cause to consider embracing bitcoin.

Before getting to the pros, one argument against Chinese authorities holding bitcoins (or encouraging the use of non-state cryptocurrencies in any way) is that bitcoin undermines Chinese capital controls. However, it's not entirely clear at present how much capital control evasion is taking place via bitcoin, which is less anonymous than originally advertised. In other words, concerns over bitcoin enabling capital control (and tax) evasion may be overblown.

Regardless of whether bitcoin actually undermines capital controls, China has made clear its intention to be a global financial power by 2020, with the renminbi taking on a global reserve currency role and Shanghai serving as a global financial centre. To achieve these objectives China must reduce capital controls and embrace open financial markets, as the United States and pre-Second World War Britain did.

The emergence of a new reserve asset (preferably, from the Chinese perspective, after China has had a chance to reduce its vast holdings of U.S. dollar denominated assets) could be seen as a positive development for China in the perennial global 'game of thrones' played by superpowers:

  1. It would dilute the status of the U.S. dollar (and market for U.S. treasury securities) as the world's dominant reserve asset.
  2. This in turn should diminish the Fed/Treasury's grip on the global financial system.

However, why wouldn't China instead prefer to see gold, another non-nation state controlled but already established reserve asset, return to prominence? After all, the People's Bank of China has been discreetly acquiring gold for years.

There are several reasons why gold is problematic. First, while the idea of boosting the reserve status of gold received some support following the 2008 financial crisis from then World Bank President Bob Zoellick and others, the 'barbarous relic' and a return to anything akin to a gold standard is still largely out of favor with economists and central bankers.

Further, even if gold came back into fashion, two problems remain from China's perspective:

  1. China's reported gold holdings still trail the U.S., Germany, IMF, etc. by a significant margin.
  2. Gold is expensive (global market cap of approximately $7 trillion); China may never catch-up to the U.S. in gold holdings.

Bitcoin, by comparison, is cheap, with a current market cap of approximately $6 billion. The U.S. government, which at one point was one of the world's largest bitcoin holders following the seizure of the Silk Road dark web marketplace, also recently liquidated its position.

Perhaps more importantly, with over half of all bitcoin mining taking place inside 'The Great Firewall of China', Chinese authorities can exert influence over bitcoin (and quietly acquire a large position). As bitcoin's software code is pliable, the rules that govern how the cryptocurrency functions can be reprogrammed. In other words, wider monetary use of bitcoin need not represent a return to the gold standard, which has been one of the chief criticisms of bitcoin amongst economists.

The exact path bitcoin would need to take to become a new reserve asset is unclear. It seems unlikely today that the IMF, PBOC and other central banks would come together and anoint bitcoin as a new reserve asset. Declining confidence in the monetary system combined with increased bitcoin use would be necessary before any such change would occur.

While bitcoin's price has recently rebounded amid currency crashes and financial instability in China and elsewhere, bitcoin still lacks a mainstream 'killer app'. The many bitcoin applications promoted by entrepreneurs and venture capitalists, such as cross-border remittances, micro and macro payments, and powering machine-to-machine transactions, have either failed to gain significant traction or are still several years off. By many measures bitcoin's advance has slowed as interest has shifted towards non-currency applications of bitcoin's underlying distributed ledger ('blockchain') technology.

Given the powerful 'lock-in' effects of established currency networks, the fact that millions of people have chosen to use bitcoin can be considered a minor economic miracle. But how much longer can bitcoin defy the odds? An influential member of the cryptocurrency community recently declared that bitcoin is in a 'death spiral'.

Many 'cryptotarians' will no doubt howl over any suggestion that state actors like the PBOC get involved with bitcoin, but support from officials may be just what bitcoin needs to continue its improbable journey. In addition to exploring its own new digital currency, the PBOC should take a close look at embracing the already existing one largely powered from within its own backyard.