By Kasun Thilina Kariyawasam
In a survey conducted by the Bank for International Settlements (BIS) in 2021, 90% of Central Banks said they were exploring Central Bank Digital Currencies or CBDCs, with 54% considering issuing one within six years.
With its CBDC – the digital renminbi (e-CNY) – China is leading the way in these efforts. Over RMB 100 billion (USD 14 billion) worth of transactions have already been conducted using the e-CNY, giving China a massive first-mover advantage.
CBDCs can address many of the inefficiencies associated with traditional fiat money, such as slow and expensive cross-border transactions. In addition to providing a secure and private means of transacting, CBDCs can enhance privacy and security. They can increase economic participation, reduce poverty, and improve economy efficiency.
These currencies can help emerging markets overcome challenges associated with traditional financial systems. By offering access to financial services to the unbanked population, CBDCs can provide financial inclusion in these countries. They can also foster innovation and competition in the financial sector, leading to the development of new products and services.
A key priority for Emerging Market Economies (EMEs) has been the advancement of less competitive industrial sectors. Increasing business velocity and reducing industrial friction, however, requires a robust industrial ecosystem. Credit channeling is the main component of such an ecosystem. A CBDC can help to build a more efficient, transparent, and inclusive ecosystem.
In addition to enabling financial inclusion, CBDC can increase access to financial services for individuals and businesses who lack access to the banking sector. Although most citizens in EMEs have a bank account, they lack the privilege of a robust credit system. In addition to having a bank account with deposits, they require certain forms of credit.
By eliminating the requirement for individuals and businesses to have a bank account or credit history to access financial services, CBDCs can therefore reduce barriers to entry. They can also reduce the entry threshold for certain services, increasing access to credit.
Banks are generally credit shy when it comes to Small and Medium Enterprises (SMEs), since collateralization is a major challenge. Digitalization can help these businesses with their cash flows, compensating for their lack of proper collateral.
In most EMEs, a robust payment system is needed. Such a system can increase efficiency, reduce transaction costs, stimulate trade and economic growth, and increase consumer confidence and trust in the financial system, leading to increased investment and spending.
A smooth functioning economy depends on an efficient and reliable payment system. With good payment systems, businesses can get paid faster and more reliably, improving their cash flow, reducing financial difficulties, and forecasting their flows more accurately.
A CDBC can reduce clearing and processing transactions costs, as well as the need for intermediaries. This can reduce financial flow costs. It can also enable more cost-effective soft Point of Sale (POS) applications. Financial fraud is one of the major challenges which EMEs face. A CBDC can provide its stakeholders with more transparent payment gateways.
CBDCs as a monetary policy tool
Although its implications for monetary policy are still unclear, CBDCs can offer new innovative monetary policy tools. To give one example, Central Banks can set interests rates for CBDCs held by commercial banks and use this to influence the overall interest rates in the economy.
By setting a positive interest rate for the CBDC, the Central Bank can incentivize commercial banks to hold more digital currencies rather than other assets, such as government bonds. This can help to increase the money supply and lower interest rates. Conversely, if the Central Bank sets a negative interest rate for the CBDC, commercial banks may be less inclined to hold it and may choose to hold other assets. This can help to reduce the money supply and raise interest rates.
CBDCs also support tiered interest rates. A tiered interest rate system allows the Central Bank to pay different interest rates on CBDC deposits. A tiered interest rate system for CBDC allows the Central Bank to pay different interest rates on CBDC deposits, depending on the amount held, which can have an impact on the overall interest rates in the economy. In turn, this can influence the overall level of interest rates in the economy by influencing demand for CBDC.
The Central Bank could pay a higher interest rate on larger CBDC deposits held by commercial banks, while paying a lower interest rate on smaller deposits. As a result, commercial banks could hold larger amounts of CBDC, increasing the money supply and lowering interest rates. A lower interest rate on small deposits could discourage commercial banks from holding small amounts of CBDC, resulting in a reduction in the money supply and a rise in interest rates. In addition, this system can be used to encourage or discourage certain types of transactions.
Central Banks can also use such currencies in open market operations to manage the CBDCs in circulation and influence interest rates. The Central Bank can increase the amount of CBDCs in circulation by purchasing the currency, which can boost money supply and lower interest rates. Conversely, it can decrease the overall level of CBDCs in circulation by selling CBDCs, which can reduce money supply and raise interest rates.
CBDCs can conduct open market operations with commercial banks, other financial institutions, and even the public. This can increase the efficiency of the monetary policy. However, the impact of CBDC open market operations will depend on factors such as the specifics of the CBDC system, the regulatory environment, and the characteristics of the economy.
Moreover, Central Banks can use CBDCs to lend to specific sectors of the economy. A Central Bank might wish to lend to a specific region facing economic challenges, such as high unemployment or deindustrialization. By providing CBDCs to commercial banks in that particular region, the Central Bank can help increase the money supply and lower interest rates, boosting growth and job creation. In the same way, a Central Bank may want to promote growth and development in a specific sector, such as small businesses or renewable energy. It can use CBDCs to this end as well.
Thus, by using CBDCs, commercial banks have more CBDCs which they can use for their operations. This can increase the circulation of CBDCs in the economy and the number of transactions that can be done using CBDCs. Additionally, this can also increase the adoption of CBDCs in the economy, as more and more commercial banks will hold CBDCs as collateral.
CBDCs can also be used for cross-border settlement by allowing for the transfer of funds between Central Banks and financial institutions. This can be done by using a blockchain-based platform that allows for real-time, secure transactions. These currencies can increase the efficiency of cross-border transactions, while reducing the need for intermediaries like correspondent banks. It can mitigate some risks associated with cross-border transactions, such as currency fluctuations.
CBDCs can mitigate some of the risks associated with cross-border transactions by providing a stable, digital currency backed by a Central Bank. Cross-border transactions can be more predictable and reliable, reducing the volatility and uncertainty associated with traditional foreign exchange markets. By pegging the value of the CBDC to a stable currency, such as the US dollar, CBDCs can minimize exposure to foreign exchange rate risks. It makes it easier for Central Banks to mitigate financial risks by reducing the impact of currency fluctuations on cross-border transactions.
By providing a digital currency which is subject to the same oversight as traditional money, CBDCs can reduce cross-border transaction compliance costs. These transactions can be conducted in compliance with local regulations, reducing the risk of fraud and laundering. CBDCs can also provide regulators with transparent transactions records, allowing them to detect suspicious activity.
To be continued…
Kasun Thilina Kariyawasam is a macroeconomist who works for the fund management sector in Sweden. He can be reached at kasunkt@hotmail.com.
Factum is an Asia Pacific-focused think tank on International Relations, Tech Cooperation and Strategic Communications accessible via www.factum.lk.
The views expressed here are the author’s own and do not necessarily reflect the organization’s.