Cryptos Are A Threat To Central Banks

Most of us go to the Bahamas for the sun and surf. Central bankers may be visiting for another reason: to check out the country’s new digital currency, the Sand Dollar. The Bahamas is one of three countries to launch a digital currency, along with China and Cambodia. Sand Dollars are now loaded in mobile wallets on smartphones; to buy a beer, simply scan a QR code—more convenient than swiping a credit card or using a grubby dollar bill.

Digital currencies aren’t yet widespread, but a race is on to get them into circulation as battle lines harden between cryptocurrencies and standbys like the dollar.

More than 85% of central banks are now investigating digital versions of their currencies, conducting experiments, or moving to pilot programs, according to PwC. China is leading the charge among major economies, pumping more than $300 million worth of a digital renminbi into its economy so far, ahead of a broader rollout expected next year. The European Central Bank, Bank of Japan, and Federal Reserve are investigating digital currencies. A “Britcoin” may eventually be issued by the Bank of England. Sweden is lining up an e-krona and might be the first cashless nation by 2023.

Money already flows through electronic circuits around the globe, of course. But central bank digital currencies, or CBDCs, would be a new kind of instrument, similar to the digital tokens now circulating in private networks. People and businesses could transact in CBDCs through apps on a digital wallet. Deposits in CBDCs would be a liability of a central bank and may bear interest, similar to deposits held at a commercial bank. CBDCs may also live on decentralized ledgers, and could be programmed, tracked, and transferred globally more easily than in existing systems.

New cryptocurrencies and payment systems are raising pressures on central banks to develop their own digital versions. Bitcoin, while popular, isn’t the main threat. It’s highly unstable—more volatile than the Venezuelan bolivar. Many investors sock it away rather than use it, and the underlying blockchain network is relatively slow.

But the cryptocurrency market overall is gaining critical mass—worth $2.2 trillion in total now, with half of that in Bitcoin. Central bankers are particularly concerned about “stablecoins,” a kind of nongovernmental digital token pegged at a fixed exchange rate to a currency. Stablecoins are gaining traction for both domestic and cross-border transactions, particularly in developing economies. Technology and financial companies aim to integrate stablecoins into their social-media and e-commerce platforms. “Central banks are looking at stablecoins the way that taxi unions look at Uber—as an interloper and threat,” says Ronit Ghose, global head of banks research at Citigroup.

While many stablecoins are now circulating—the largest is Tether, with $51 billion in circulation, versus $2.2 trillion for the dollar—a big one may be arriving soon in Diem, a stablecoin backed by Facebook (ticker: FB). Diem may launch this year in a pilot program, reaching Facebook’s 1.8 billion daily users; it’s also backed by Uber and other companies. The potentially rapid spread of Diem is raising the ante for central bankers. “What really changed the debate is Facebook,” says Tobias Adrian, financial counsellor at the International Monetary Fund. “Diem would combine a stablecoin and payments platform into a vast user base around the world. That’s potentially very powerful.”

The broader force behind CBDCs is that money and payment systems are rapidly fracturing. In the coming years, people might hold Bitcoin as a store of value, while transacting in stablecoins pegged to euros or dollars. “The private sector is throwing down the gauntlet and challenging the central bank’s role,” says economist Ed Yardeni of Yardeni Research.

The dollar won’t disappear, of course—it’s held in vast reserves around the world and used to price everything from computers to steel. But every fiat currency now faces more competition from cryptos or stablecoins. And stablecoins in widespread use could upend the markets since they aren’t backstopped by a government’s assets; a hack or collapse of a stablecoin could send shock waves as people and businesses clamor for their money back, sparking a bank run or financial panic. And since they’re issued by banks or other private entities, they pose credit and collateral risks.

As commerce shifts to these digital coins, along with other cryptocurrencies and peer-to-peer networks, governments risk losing control of their monetary policies—tools that central banks use to keep tabs on inflation and financial stability. “Central banks need to create digital currencies to maintain monetary sovereignty,” says Princeton University economist Markus Brunnermeier. The Fed, for instance, manages the money supply by buying or selling securities that expand or contract the monetary base, but “if people aren’t using your money, you have a big problem,” says Rutgers University economist Michael Bordo.

It isn’t all about playing defense, though. Proponents of CBDCs say there are economic and social benefits, such as lower transaction fees for consumers and businesses, more-effective monetary policies, and the potential to reach people who are now “unbanked.” CBDCs could also help reduce money laundering and other illegal activities now financed with cash or cryptos. And since central banks can’t stop the rise of privately issued digital money, CBDCs could at least level the playing field.

While CBDCs have bounced around academia for years, China’s pilot project, launched last year, was a wake-up call. Analysts say China aims to get its digital renminbi into circulation for cross-border transactions and international commerce; the standard renminbi now accounts for 2.5% of global payments, well below China’s 13% share of global exports, according to Morgan Stanley.

In China, transactions on apps like Alipay and WeChat now exceed the total world volume on Visa (V) and Mastercard (MA) combined. The Chinese apps have also become platforms for savings, loans, and investment products. CBDCs could help regulators keep tabs on money flowing through the apps, and help prevent stablecoins from usurping the government’s currency. “That’s why the People’s Bank of China had to claim its property back—for sovereignty over its monetary system,” says Morgan Stanley chief economist Chetan Ahya.

Momentum for digital currencies is also building for “financial inclusion”—reaching people who lack a bank account or pay hefty fees for basic services like check cashing. About seven million U.S. households, or 5% of the total, are unbanked, according to the Federal Deposit Insurance Corp. Democrats in Congress recently proposed legislation for a digital-dollar wallet called a FedAccount, partly to reach the financially disadvantaged.

Governments could also target economic policies more efficiently. Stimulus checks could be deposited into e-wallets with digital dollars. That could bypass checking accounts or apps that charge fees. It could be a way to get money into people’s hands faster and see how it’s spent in real time. Digital currencies are also programmable. Stimulus checks in CBDC could vanish from a digital wallet in three months, incentivizing people to spend the money, giving the economy a lift.

Researchers at the Bank of England estimate that if a digital dollar went into widespread circulation, it could permanently lift U.S. output by 3% a year. That may be a stretch, but central banks, including the Fed, are now building systems for banks to settle retail transactions almost instantly, 24/7, at negligible cost. CBDCs could slide into that infrastructure, cutting transaction fees and speeding up commerce. That could reduce economic friction and lead to productivity gains for the economy.

Some economists view CBDCs as a monetary-policy conduit, as well. Deposits of $1 million or more in CBDCs, for instance, might incur a 0.25% fee to a central bank, disincentivizing people and institutions from hoarding savings in a protracted slowdown. “It’s costly for the economy if wealthy people shift money into cash or equivalent securities,” says Dartmouth College economist Andrew Levin. “This would disincentivize that from happening.”

Digital currencies aren’t without controversy, though, and would need to overcome a host of technological issues, privacy concerns, and other hurdles. For one, they could make it easier for governments to spy on private-party transactions. Anonymity would need strong safeguards for a CBDC to reach critical mass in North America or Europe. Chinese officials have said their CBDC will preserve privacy rights, but critics say otherwise. The country’s new CBDC could “strengthen its digital authoritarianism,” according to the Center for a New American Security, a think tank in Washington, D.C.

There are challenges for commercial banks, too. Central banks could compete with commercial banks for deposits, which would erode banks’ interest income on assets and raise their funding costs. Various proposals address those concerns, including compensating banks for services in CBDCs. Deposit rates would have to be competitive so that central banks don’t siphon deposits. But even in a two-tier financial model, commercial banks could lose deposits, pushing them into less stable and higher-cost sources of funding in debt or equity markets.

More disconcerting for banks: They could be cut out of data streams and client relationships. Those loops are critical to selling financial services that can generate more revenue than lending. “CBDCs will pose more competition to the banking sector,” says Ahya. “It’s about the loss of data and fee income from financial services.”

Banks in the U.S., Europe, and Japan don’t face imminent threats, since regulators are going slow. As incumbents in the system, banks still have vast advantages and could use CBDCs as a means of cross-selling other services. Most of the advanced CBDC projects are for wholesale banking, like clearing and settlement, rather than consumer banking. The ECB, for instance, has said it may limit consumer holdings to 3,000 euros, or about $3,600, in a rollout that may not kick off until 2025.

A timeline for a digital dollar hasn’t been revealed by the Fed and may take congressional action. More insights into the Fed’s thinking should be coming this summer: The Boston Fed is expected to release its findings on a prototype system. One compromise, rather than direct issuance, is “synthetic” CBDC—dollar-based stablecoins that are issued by banks or other companies, heavily regulated, and backed by reserves at a central bank.

Whatever they develop, central banks can’t afford to be sidelined as digital tokens blend into social-media, gaming, and e-commerce platforms—competing for a share of our wallets and minds. Imagine a future where we live in augmented reality, shopping, playing videogames, and meeting digital avatars of friends. Will we even think in terms of dollars in these walled gardens? That future isn’t far off, says the economist Brunnermeier. “Once we have these augmented realities, competition among currencies will be more pronounced,” he says. “Central banks have to be part of this game.”

For years, global companies showcased their Chinese operations as a source of robust growth. A burgeoning middle class, a stream of people moving to cities, and the creation of new services to cater to them—along with the promise of the further opening of the world’s second-largest economy—drew companies eager to tap into the action.

Then Covid hit, isolating China from much of the world. Chinese leader Xi Jinping tightened control of the economy, and U.S.-China relations hit a nadir. After decades of rapid growth, China’s economy is stuck in a rut, with increasing concerns about what will drive the next phase of its growth.

Though Chinese officials have acknowledged the sputtering economy, they have been reluctant to take more than incremental steps to reverse the trend. Making matters worse, government crackdowns on internet companies and measures to burst the country’s property bubble left households and businesses scarred.

Lowered Expectations

Now, multinational companies are taking a hard look at their Chinese operations and tempering their outlooks. Marriott International narrowed its global revenue per available room growth rate to 3% to 4%, citing continued weakness in China and expectations that demand could weaken further in the third quarter. Paris-based Kering , home to brands Gucci and Saint Laurent, posted a 22% decline in sales in the Asia-Pacific region, excluding Japan, in the first half amid weaker demand in Greater China, which includes Hong Kong and Macau.

Pricing pressure and deflation were common themes in quarterly results. Starbucks , which helped build a coffee culture in China over the past 25 years, described it as one of its most notable international challenges as it posted a 14% decline in sales from that business. As Chinese consumers reconsidered whether to spend money on Starbucks lattes, competitors such as Luckin Coffee increased pressure on the Seattle company. Starbucks executives said in their quarterly earnings call that “unprecedented store expansion” by rivals and a price war hurt profits and caused “significant disruptions” to the operating environment.

Executive anxiety extends beyond consumer companies. Elevator maker Otis Worldwide saw new-equipment orders in China fall by double digits in the second quarter, forcing it to cut its outlook for growth out of Asia. CEO Judy Marks told analysts on a quarterly earnings call that prices in China were down roughly 10% year over year, and she doesn’t see the pricing pressure abating. The company is turning to productivity improvements and cost cutting to blunt the hit.

Add in the uncertainty created by deteriorating U.S.-China relations, and many investors are steering clear. The iShares MSCI China exchange-traded fund has lost half its value since March 2021. Recovery attempts have been short-lived. undefined undefined And now some of those concerns are creeping into the U.S. market. “A decade ago China exposure [for a global company] was a way to add revenue growth to our portfolio,” says Margaret Vitrano, co-manager of large-cap growth strategies at ClearBridge Investments in New York. Today, she notes, “we now want to manage the risk of the China exposure.”

Vitrano expects improvement in 2025, but cautions it will be slow. Uncertainty over who will win the U.S. presidential election and the prospect of higher tariffs pose additional risks for global companies.

Behind the Malaise

For now, China is inching along at roughly 5% economic growth—down from a peak of 14% in 2007 and an average of about 8% in the 10 years before the pandemic. Chinese consumers hit by job losses and continued declines in property values are rethinking spending habits. Businesses worried about policy uncertainty are reluctant to invest and hire.

The trouble goes beyond frugal consumers. Xi is changing the economy’s growth model, relying less on the infrastructure and real estate market that fueled earlier growth. That means investing aggressively in manufacturing and exports as China looks to become more self-reliant and guard against geopolitical tensions.

The shift is hurting western multinationals, with deflationary forces amid burgeoning production capacity. “We have seen the investment community mark down expectations for these companies because they will have to change tack with lower-cost products and services,” says Joseph Quinlan, head of market strategy for the chief investment office at Merrill and Bank of America Private Bank.

Another challenge for multinationals outside of China is stiffened competition as Chinese companies innovate and expand—often with the backing of the government. Local rivals are upping the ante across sectors by building on their knowledge of local consumer preferences and the ability to produce higher-quality products.

Some global multinationals are having a hard time keeping up with homegrown innovation. Auto makers including General Motors have seen sales tumble and struggled to turn profitable as Chinese car shoppers increasingly opt for electric vehicles from BYD or NIO that are similar in price to internal-combustion-engine cars from foreign auto makers.

“China’s electric-vehicle makers have by leaps and bounds surpassed the capabilities of foreign brands who have a tie to the profit pool of internal combustible engines that they don’t want to disrupt,” says Christine Phillpotts, a fund manager for Ariel Investments’ emerging markets strategies.

Chinese companies are often faster than global rivals to market with new products or tweaks. “The cycle can be half of what it is for a global multinational with subsidiaries that need to check with headquarters, do an analysis, and then refresh,” Phillpotts says.

For many companies and investors, next year remains a question mark. Ashland CEO Guillermo Novo said in an August call with analysts that the chemical company was seeing a “big change” in China, with activity slowing and competition on pricing becoming more aggressive. The company, he said, was still trying to grasp the repercussions as it has created uncertainty in its 2025 outlook.

Sticking Around

Few companies are giving up. Executives at big global consumer and retail companies show no signs of reducing investment, with most still describing China as a long-term growth market, says Dana Telsey, CEO of Telsey Advisory Group.

Starbucks executives described the long-term opportunity as “significant,” with higher growth and margin opportunities in the future as China’s population continues to move from rural to suburban areas. But they also noted that their approach is evolving and they are in the early stages of exploring strategic partnerships.

Walmart sold its stake in August in Chinese e-commerce giant JD.com for $3.6 billion after an eight-year noncompete agreement expired. Analysts expect it to pump the money into its own Sam’s Club and Walmart China operation, which have benefited from the trend toward trading down in China.

“The story isn’t over for the global companies,” Phillpotts says. “It just means the effort and investment will be greater to compete.”

Corrections & Amplifications

Joseph Quinlan is head of market strategy for the chief investment office at Merrill and Bank of America Private Bank. An earlier version of this article incorrectly used his old title.

Cryptos Are A Threat To Central Banks

Why it goes beyond Bitcoin.

Multinationals like Starbucks and Marriott are taking a hard look at their Chinese operations—and tempering their outlooks.

Lowered Expectations

Behind the Malaise

Sticking Around