Why Nobody Invests in Japan
Tokyo’s Failure to Welcome Foreign Capital Is Hobbling Its Economy
Imagine that it is 2022 and the United States has received intelligence from the Mossad that Iran is procuring essential components for nuclear weapons and missile programs. U.S. economic sanctions on Iran remain in place, but Iran has shifted much of its international commerce to a new yuan-based system—a Chinese digital currency that allows Tehran to avoid dollar transactions and thus evade U.S. financial institutions. As a result, Iran’s oil sales to China, India, and Europe are up, providing the Iranian regime with critical revenue streams that U.S. authorities cannot monitor. And when Iran decides to move quickly toward the development of nuclear weapons and new medium-range missiles to deliver them, the United States can no longer turn to sanctions as one of its primary means of responding to the threat.
This scenario may seem far-fetched given the long-standing dominance of the dollar. But in late April, China reached a significant milestone: after more than five years of research by its central bank, China became the first major economy to conduct a real-world test of a national digital currency. The pilot project, which is occurring in four large Chinese cities, is a clear sign that China is years ahead of the United States in the development of what is likely to become a central component of a digital world economy.
U.S. policymakers are unprepared for the consequences. The advent of digital currencies will degrade the efficacy of U.S. sanctions, limiting the country’s options to respond to national security threats from Iran, North Korea, Russia, and others. It will also hamper the ability of U.S. authorities to track illicit financial flows. And China, meanwhile, will use the combination of its digital yuan and strong electronic-payment platforms (such as Alipay and WeChat) to expand its influence and reinforce its capacity for economic coercion in Africa, the Middle East, and Southeast Asia.
Rather than resting on the laurels of the dollar’s decades-long dominance, the United States must act now to protect its economic advantage in the coming era of national digital currencies. In part, this will require reconsidering the aggressive unilateral use of sanctions and other coercive economic policy tools, which has spurred other nations to seek alternatives to the U.S.-led and dollar-dominated global financial system. But it will also require launching a “digital dollar initiative,” an effort that brings the government together with the private sector to develop a digital national currency. Otherwise, the failure to check the influence of China’s digital yuan and develop a competitive American alternative could significantly hinder the United States’ global influence in the information age.
Chinese President Xi Jinping’s hallmark economic development strategy, “Made in China 2025,” aims to turn China into a leader in cutting-edge technology. Accordingly, when China’s central bank determined in 2014 that a state-backed digital currency had the potential to protect its financial autonomy and heighten its international economic influence, the essential ingredients—artificial intelligence, blockchain technology, and digital-payment platforms—were already under development.
A digital currency is any form of money that exists in electronic form, as opposed to a tangible bill or coin. Deposits held in commercial banks today are already digital, but they are the liability of private firms—that is, privately owned banks are obligated to turn deposits into cash whenever a depositor wants. China’s central bank-issued digital currency would be the liability of the state, just as cash is. Although this change may seem insignificant from the perspective of end users, it is fundamental, since a central bank has much more authority and oversight over digital money that it issues.
Last year, China’s efforts to master a digital currency accelerated when Facebook unveiled Libra, a digital token administered by a consortium of mostly technology and finance companies and backed by a basket of U.S. dollars, British pounds, euros, and Japanese yen. “While we debate these issues, the rest of the world isn't waiting,” Mark Zuckerberg, the Facebook CEO, testified to Congress last October. “China is moving quickly to launch similar ideas in the coming months.” Ironically, Zuckerberg’s push to make Facebook the steward of a globalized monetary system catalyzed China’s efforts to roll out its own digital currency. “If Libra is accepted by everyone and becomes a widely used payment tool, then after some time, it is entirely possible that it will develop into a global, super-sovereign currency,” a top official at China’s central bank said after Libra was announced. “We need to plan ahead to protect our monetary sovereignty.”
China’s efforts to master a digital currency accelerated when Facebook unveiled Libra, a digital token administered by a consortium of mostly technology and finance companies and backed by a basket of currencies.
The digital yuan is a far cry from bitcoin, the project that first put digital currencies on the map. Bitcoin uses peer-to-peer technology to operate with no central administrator. Several million users maintain independent ledgers of all transactions within a distributed system and use consensus mechanisms to agree on which transactions are valid. Cryptographic technology is supposed to ensure that users’ identities and transaction records are private, secure, and immutable. But the weaknesses of this model—wildly fluctuating values and vulnerability to cyberattacks—has kept bitcoin and other “cryptocurrencies” from becoming more than speculative assets.
By contrast, the digital yuan is hypercentralized. It is controlled by the People’s Bank of China (PBOC) and integrated with China’s current banking system. It will likely follow a two-tier structure, with the PBOC issuing digital coins to a network of state-owned banks and payments firms, such as Alipay and WeChat, which in turn will distribute them to individuals and businesses through mobile banking and payments apps. At the heart of the monetary system will be a ledger overseen by the PBOC and administered by the network that documents all transactions and instantaneously moves digital balances among members. With this structure, the digital yuan is likely to overcome the three major hurdles that have prevented cryptocurrencies from achieving scale: price stability, wide acceptability through ubiquitous payment platforms, and legitimacy in the eyes of governments and regulators.
For China, part of the appeal of a digital currency is its use in domestic retail payments. (And indeed, other countries, especially emerging markets, that are exploring their own digital currencies are primarily interested in domestic payments efficiency and financial inclusion, according to a survey by the Bank of International Settlements.) Given that 80 percent of smartphone users in China already use mobile-payment platforms, however, the real benefit will come with the expansion of Chinese economic and strategic influence abroad.
The backbone of the United States’ financial dominance is the Society for Worldwide Interbank Financial Telecommunication (SWIFT), which facilitates messages between banks about payments orders, and a network of U.S. correspondent banks, which serves as intermediary to execute international payments. Most cross-border payments—nearly $5 trillion per day—are directed through SWIFT messages, and a significant portion are routed through U.S. correspondent banks. Information sharing with these institutions allows U.S. authorities to identify illicit activity, such as money laundering and terrorist financing. (For example, the U.S. Treasury’s Terrorist Finance Tracking Program (TFTP), a post-9/11 initiative to monitor al Qaeda and other terror networks, relies on information subpoenaed from SWIFT to investigate suspected international terrorists and their networks.)
But perhaps more important, this system gives the United States enormous leverage over other states, since sanctions that cut a country off from this network are usually a death sentence. Over the past decades, Washington has relied more heavily on sanctions as a core foreign policy tool, increasing both the frequency of their use (new designations spiked in the first two years of the Trump administration and were already on the rise before that) and the scope of issues they are meant to address (the number of sanctions programs increased threefold from 2009 to 2019).
Nations on the receiving end have in turn become increasingly resentful. But it is not just U.S. adversaries who see the appeal of having an alternative to dollar-based, cross-border transactions; even some U.S. allies are looking for ways to undercut this leverage. Last year, the governor of the United Kingdom’s central bank, Mark Carney, called for an international digital currency that could “dampen the domineering influence of the U.S. dollar on global trade.” Russia has developed a SWIFT alternative called the System for Transfer of Financial Messages (SPFS); China has its own version called the Cross-Border Interbank Payments System (CIPS); and five EU nations have joined the Instrument in Support of Trade Exchanges (INSTEX), which aims to facilitate non-SWIFT and nondollar denominated transactions, primarily with Iran.
It is not just U.S. adversaries who see the appeal of having an alternative to dollar-based, cross-border transactions; even some U.S. allies are looking for ways to undercut this leverage.
Digital currencies further the goal of avoiding dollar transactions and U.S. financial oversight, since they provide a scalable cross-border mechanism that circumvents the current system. The central banks of Canada and Singapore are already exploring the use of smart contracts to pass messages between digital currency systems, and monetary authorities in Hong Kong and Thailand have tested bilateral payments in their respective currencies without intermediaries. Such initiatives demonstrate the potential to complete cross-border transactions without SWIFT and without U.S. correspondent banks, two critical pillars of U.S. financial dominance. The European Central Bank has also created a working group with the central banks of Canada, Japan, Sweden, Switzerland, and the United Kingdom to explore cross-border interoperability of national digital currency projects.
The digital yuan could play an especially important role in advancing such efforts, bolstered by China’s clear interest in facilitating international commerce in a way that undermines U.S. influence and expands its own. In some places, Beijing might simply share its “technology stack” or expertise to accelerate the development of digital currencies by other governments motivated to evade U.S. oversight. For example, Iran could use Chinese technology to issue a digital rial that is fully interoperable with the Chinese system. For those countries in Africa, the Gulf, and Southeast Asia that are already in China’s economic orbit, Beijing could push the use of the digital yuan itself. Just as it is funding physical infrastructure projects today through its Belt and Road Initiative, China could invest in point-of-sale terminals, ATMs, mobile apps, and other financial infrastructure that creates a complementary “digital Belt and Road.” Individuals sending or receiving remittances and businesses with large import or export ties to China, for example, could transact in the digital yuan using Alipay. And by stipulating that importers receive payment in the digital yuan, or requiring contractors for the real-world BRI to repay loans using it, China could both increase demand for its national currency and bring more users into a network that it can closely monitor.
China has much to gain from pioneering a scalable state-backed digital currency. Chinese finance and tech firms at the forefront of the digital Belt and Road will capture the revenue from facilitating cross-border payments. The PBOC will have a panopticon view of all transactions in the digital yuan and potentially, on all transactions in systems that leverage its technology, strengthening its information advantage. Chinese officials have described the system as offering “controlled anonymity,” giving the government another data set to not only identify illicit activity but also target political dissidents and minorities. And Chinese cooperation, already important, will become a linchpin in multilateral sanctions and other economic agreements.
Meanwhile, U.S. economic influence will be undercut, starting with less effective sanctions. Going forward, Washington would, for example, be hindered from unilaterally withdrawing from arrangements such the Iran nuclear deal, as it did in 2018, since European countries could simply extend Iran a line of credit (as they wanted to do in 2019) or trade with Iran (as they are trying to do through INSTEX) using digital currencies that do not rely on U.S. market infrastructure. Not only would the United States be unable to sanction this activity, but authorities would also be limited in their ability to track it. The U.S. intelligence community could no longer rely on financial transaction data to see if Iran was purchasing nuclear materials.
Over the past several decades, U.S. economic power has served as the foundation for U.S. global might. Until now, Washington could take comfort in the fact that the U.S. financial system was truly unrivaled. Now policymakers must decide how to protect it in an era when China—or even a private company, such as Facebook—can challenge American banks and payments infrastructure.
A digital dollar initiative will combine the strength and stability of the U.S. dollar with the convenience and efficiency of digital technology. Launching the initiative will be difficult. Financial institutions and technology companies will likely see a threat to their proprietary digital payments solutions; U.S. policymakers and regulators will quickly need to fill knowledge gaps in digital payments technologies; and a slew of regulatory and policy changes will be required to, for example, protect user privacy and ensure data and system security in a more digitized economy.
So far, the U.S. Federal Reserve has been cautious but slow. In a speech last fall, Lael Brainard, a member of the Federal Reserve’s Board of Governors, outlined significant obstacles related to issuing and administering a digital dollar, including the need to establish the Fed’s legal authority to issue money in digital form; the need to develop operational capacity to manage a digital currency (protecting user privacy, preventing counterfeiting, mitigating cyber risks); and the need to understand its implications for monetary policy and financial stability. These are real challenges that the digital dollar initiative must address. Yet the result of inaction will be that over time, payments flows will migrate to a digital ecosystem that is built and administered by foreign entities. The delays and technical glitches encountered in disbursing COVID-19-related stimulus payments to American households and businesses have already illustrated the deep inefficiencies of the U.S. payments network.
U.S. policymakers must also reconsider the near-reflexive use of unilateral and secondary sanctions (which prohibit dealing not only with sanctioned entities but also with third parties who deal with them) to address national security threats. As the former Treasury Secretary Jack Lew has pointed out, “we must be conscious of the risk that overuse of sanctions could undermine our leadership position within the global economy, and the effectiveness of our sanctions themselves.” When the need for sanctions is compelling, Washington should make sure to bring other governments, especially those of important allies, on board. The overuse of unilateral sanctions especially pushes other nations to look for alternatives, and China’s digital yuan could be exactly the solution that both allies and rogue nations seek.
Ultimately, and inevitably, monetary systems are headed toward greater digitization and independence from U.S. intermediaries. Policymakers will need to respond by formulating multinational data-sharing agreements, guidelines for interoperable digital systems, and privacy regulations for cross-border payments data. U.S. policymakers should take a leading role in these efforts to prevent a fragmented payments system rather than letting other nations dictate the terms.
U.S. Financial Power Depends on Washington, Not Beijing