Dr Alessandro Arduino is the co-director of the Security & Crisis Management programme at the Shanghai Academy of Social Science (SASS) and was a visiting senior fellow with the China Programme at the S Rajaratnam School of International Studies (RSIS), Nanyang Technological University, Singapore.

In this article, Arduino addresses China’s role in the global digital currency markets and how domestic investors and regulators could impact its development.

2016 began in China with two sequential market crashes that forced the regulators to intervene in the Shanghai and Shenzhen stock exchanges.

As they did in response to the stock bubble that burst in 2015, Chinese regulators intervened to organise a centrally planned recovery. Despite a stimulus of US$20bn that the People’s Bank of China (PBoC) pumped into the market during the 5th January market crash, the yuan kept weakening.

Gold, as the usual commodity of refuge for investors during uncertain times, started to gain momentum.

At the same time, the virtual currencies that employ heavy cryptography and blockchain technology, such as bitcoin, have increased in value thanks to Chinese investments.

Cryptocurrencies and capital controls

Cryptocurrencies – bitcoin in primis – are poised to increase vulnerabilities and uncertainty in the Chinese economy during 2016.

The security concerns for China are a broad threat spectrum. The immediate one is associated with increased capital flight that relies on bitcoin as a tool to avoid strict Chinese capital controls.

Another concern is over the possible collapse of virtual Ponzi schemes, based on the promise of easy profits in virtual currencies, which are increasingly attracting a cross-section of Chinese society along with their savings.

The collapse of one of these virtual pyramid schemes, that take advantage of the grey area in the Chinese financial regulations, could start a domino effect that within a few hours could consume the lifetime savings of un-savvy Chinese investors.

The collapse of these fraudulent schemes, or even the implosion of more legitimate funds linked to bitcoin, could ignite severe social unrest, greater than that witnessed during the October 2007 stock market crash.

Over the long term, several other threats related to the use of bitcoin are expected to affect China’s security. These threats include the lack of accountability in China’s growing shadow economy, as well as providing an additional tool for the financing of terrorism and illegal activities such as kidnappers’ rings.

Just in the last months of 2015, a high-level case of kidnapping involving the Hong Kong tycoon Wong Kwan resulted in a bitcoin ransom demand.

In 2015, the Chinese government’s options in support of the stock market ranged from capital inflow restrictions to jail terms for short-sellers (traders who were betting against the market, thus profiting from the fall).

In 2016, these options are more limited due to the dwindling foreign trade account surplus and the risks related to the possible burst of the provincial government and state-owned enterprises (SOEs) bad loan bubble, which could very well absorb the remaining reserves.

In parallel with the yuan devaluation, the Chinese online bitcoin exchanges (such as OKCoin, Huobi and BTCC) are experiencing an increased spread in the BTC/USD exchange rate.

A weaker yuan will attract an increasing number of Chinese to hold assets denominated in bitcoin.

Yuan and cryptocurrency links

To assuage the concern of several western countries, China needs to take additional measures to address the unregulated use of digital currency, particularly money laundering and terrorist financing.

The anonymity that is at the base of cryptocurrencies is prone to abuse and must be taken into account when framing new regulations and policies.

However, bitcoin does not need to be stigmatised as a “terrorist currency” as it is just a medium for value transfer. In this respect, calls to criminalize bitcoin are not substantiated and could be the same as a demand to stop using the US dollar since it is the preferred currency in global drugs and arms transactions.

Considering the role of the yuan with bitcoin, it is also possible to infer that future Chinese regulatory policies will have a greater influence on the bitcoin’s global value.

While PBoC is currently focused on containing the volatility of the yuan, constraining additional capital outflows and limiting the pressure to depreciate the currency, there is an urgent need for a long-term Chinese approach in dealing with cryptocurrencies, particularly their use for illicit purposes.

Due to the size of its economy, China now has an important impact on the global financial system. At the same time, the influence of China over the value of and use of bitcoin is growing rapidly.

China therefore also bears the responsibility to provide practical solutions that will enable and perhaps even regulate the legitimate uses of cryptocurrencies.

This piece originally appeared as part of RSIS Commentary, a platform for provide policy-relevant commentary curated by S. Rajaratnam School of International Studies, and has been republished with the author’s permission.

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