Central Bank Digital Currencies: Coming Soon?
For ages, money resided in the physical realm - from crumpled bills to imposing bank vaults that solely guarded this concrete wealth. But then came the programmers with their abstruse code, not to disrupt, but to modernize currency for an era where impenetrably complex tech rules all. In a world where Byzantine technology increasingly governs all facets of life, why should cold currency remain an analog antique? No, the central bankers are recognising that it's time to absorb money's new digital incarnation fully into their institutionalized control. Call it the world's most lucrative software update.
At the forefront of this revolution are Central Bank Digital Currencies (CBDCs), a new form of digital money that promises—or perhaps threatens, depending on one's perspective—to radically reshape the way we think about and use currency. CBDCs, for the uninitiated, are digital versions of a country's fiat currency, issued and backed by the central bank, that can be used for electronic payments and transfers. A recent report by the International Monetary Fund (IMF) on CBDCs and digital payments in sub-Saharan Africa serves as a poignant reminder of the potential CBDCs have to rewriting the rules of the global economic game as almost 75% of central banks in sub-Saharan Africa “are engaged in—or are planning to engage in—CBDC research or pilot activities”.
While CBDCs offer significant potential benefits, policymakers must carefully address risks to financial stability to ensure a positive outcome. In this article, we'll dive deep into the world of CBDCs, exploring their economic and political implications, their potential to promote financial inclusion, and the challenges they pose to the long-established monetary order.
CBDCs vs. Classical Central Bank Systems
Central Bank Digital Currencies mark a dramatic departure from the traditional central banking model. In a classical system, central banks issue physical cash and manage the money supply through various monetary policy tools, such as setting interest rates and conducting open market operations. Commercial banks play a crucial role in this system, acting as intermediaries between the central bank and the public.
In contrast, CBDCs are digital tokens issued directly by the central bank to individuals and businesses. This direct relationship between the central bank and the public could potentially remove the need for the intermediate role of commercial banks entirely, fundamentally altering the structure of the financial system. With CBDCs, central banks could exert a more direct and potent influence over the money supply and could implement monetary policy more directly, without relying on commercial banks to transmit policy changes to the wider economy.
Key differences at a glance:
Issuance: CBDCs are issued directly by the central bank, while physical cash is issued by central banks and distributed through commercial banks.
Form: CBDCs are digital tokens, while classical systems use physical cash.
Accessibility: CBDCs can be accessed through digital wallets, while physical cash is accessible through bank accounts and ATMs.
Monetary Policy: CBDCs allow for more direct and targeted monetary policy implementation, while classical systems rely on commercial banks to transmit policy changes.
Furthermore, CBDCs could provide central banks with real-time data on economic activity, enabling them to make more informed policy decisions. This enhanced visibility could help central banks to identify and respond to potential risks more quickly, potentially enhancing financial stability. However, this increased power and control also raises concerns about the concentration of economic power in the hands of unelected officials, and the potential for abuse or mismanagement.
As we explore the differences between CBDCs and traditional central banking systems, it's crucial to consider the potential benefits, risks, and opportunities that CBDCs present.
Benefits, Risks, and Opportunities
CBDCs offer a promising solution to the persistent problem of financial exclusion. By providing a digital alternative to cash that can be accessed through mobile phones, CBDCs could extend the reach of formal financial services to many of the estimated 1.7 billion adults worldwide who are unbanked. This increased accessibility could help to bridge the financial inclusion gap, enabling more people to participate in the digital economy and access the benefits of formal financial services. Furthermore, CBDCs could significantly reduce transaction costs and settlement times, particularly for cross-border payments, fostering more efficient trade and commerce.
In countries like Kenya, where the mobile money service M-Pesa has already revolutionized financial inclusion, CBDCs could take this progress even further. One of the most transformative aspects of CBDCs is their ability to enable direct, peer-to-peer transactions without intermediaries. This could significantly slash costs and barriers to entry for financial services, making them far more accessible to historically marginalized populations. Furthermore, CBDCs could enable governments to distribute social welfare payments and other forms of financial assistance directly to citizens' digital wallets, enhancing the efficiency and effectiveness of these programs.
However, the economic risks of CBDCs cannot be swept under the rug. The introduction of a digital currency could potentially disrupt the existing financial system, leading to disintermediation of banks and other financial institutions. This could have unintended consequences for credit creation and financial stability. For instance, the disintermediation of banks could lead to a reduction in credit availability, particularly for small businesses and individuals who rely on bank lending. Additionally, the rapid shift away from bank deposits could increase the risk of bank runs during economic downturns, potentially destabilizing the financial system.
Can the promise of financial inclusion truly be realized, or will the digital divide leave the unbanked further behind in a world of cold, ethereal currencies?
While CBDCs offer a range of potential benefits and opportunities, their impact on monetary policy and financial stability is maybe even more revolutionary.
Stability and Steerability for Central Banks
CBDCs represent an unprecedented and potent addition to the central bank toolkit, with far-reaching implications for monetary policy and financial stability1. By providing a digital alternative to cash, central banks could potentially enhance their ability to implement monetary policy, particularly in times of crisis. For example, CBDCs could enable central banks to impose negative interest rates, encouraging spending and investment during economic downturns.
With CBDCs, central banks can use tools such as programmable money, precision-targeted stimulus payments, and real-time monitoring of financial transactions to enhance their ability to steer the economy. However, the increased steerability of CBDCs also raises questions about the independence of central banks. In Venezuela, for instance, the lack of central bank independence has directly contributed to hyperinflation, economic instability, and a severe erosion of public trust in the country's financial system, as the government has used the central bank to finance its deficit spending and manipulate the currency2.
Additionally, the ability to track and control the flow of money in real-time could potentially politicize monetary policy, as governments seek to influence central bank decision-making for political gain. This could undermine the credibility and effectiveness of central banks, leading to a loss of public trust in the financial system.
Political Implications
The adoption of CBDCs could have significant political implications, both domestically and internationally. On the domestic front, CBDCs could provide governments with new tools for fiscal policy, such as targeted stimulus payments or social welfare programs. The ability to distribute funds directly to citizens' digital wallets could enhance the efficiency and effectiveness of government support during times of crisis.
However, CBDCs also raise concerns about privacy and government overreach. The digital nature of CBDCs could enable governments to track and monitor citizens' financial transactions, potentially infringing upon civil liberties. This could lead to a backlash from privacy advocates and civil society groups, who fear the erosion of individual freedoms in the name of economic progress.
The introduction of CBDCs could have significant implications for monetary policy transmission and the role of commercial banks in the financial system. In a traditional monetary system, central banks rely on commercial banks to transmit changes in interest rates and other policy tools to the wider economy. However, with CBDCs, central banks could bypass commercial banks altogether, interacting directly with individuals and businesses.
This disintermediation of commercial banks was already mentioned above as a potential driver for financial inclusion. However, at the governance level it could enhance the speed and effectiveness of monetary policy transmission, enabling central banks to respond more quickly to economic shocks and crises. On the other hand, it could also reduce the role of commercial banks in credit creation and financial intermediation, potentially leading to a contraction in lending and economic activity.
Furthermore, the adoption of CBDCs could lead to a shift in the composition of commercial bank balance sheets, as customers move their deposits from traditional bank accounts to CBDC wallets. This could put pressure on banks' funding models and profitability, potentially leading to consolidation in the banking sector.
The Dominance of the US Dollar
One of the most significant geopolitical implications of CBDCs is their potential to challenge the dominance of the US dollar as the world's reserve currency. Today, the US dollar is used for the majority of international trade and financial transactions, giving the United States significant economic and political leverage on the global stage.
However, the rise of CBDCs could provide an alternative to the US dollar for international settlements, particularly for countries that are seeking to reduce their dependence on the US-led financial system. For example, China's digital yuan project3 can be seen as an attempt to internationalize the Chinese currency and challenge the US dollar's supremacy.
If other major economies, such as the European Union or Japan, were to launch their own CBDCs, it could lead to a more multipolar international monetary system, with a range of digital currencies competing for global influence. This could have significant implications for the balance of economic power in the world, and could potentially erode the United States' ability to use its financial clout to advance its geopolitical interests.
In the battle for global monetary supremacy, will the rise of digital currencies lead to a new era of economic warfare, with nations wielding their CBDCs as weapons in a struggle for power and control?
Conclusion
The era of CBDCs is closer than many might expect, with numerous pilot projects and initiatives already underway across the globe. From China's digital yuan to Sweden's e-krona, central banks are actively exploring the transformative potential of digital currencies to transform the financial landscape. As these projects gain momentum, it is becoming increasingly clear that CBDCs are not merely a theoretical concept but a tangible reality that will soon shape the future of money and finance.
As the world of finance waits for this groundbreaking shift, it is crucial that we approach the development and implementation of CBDCs with a spirit of collaboration, innovation, and a commitment to fostering a more inclusive, efficient, and resilient global financial system. The challenges are significant, ranging from the thorny issues of privacy and security to existential questions surrounding the role of commercial banks and the impact on monetary policy. Yet, the potential benefits are also enormous, from the promise of financial inclusion and reducing transaction costs to enhanced efficacy of monetary policy and the fortification of the financial system.
See, e.g., Davoodalhosseini, S. M. (2022). Central bank digital currency and monetary policy. Journal of Economic Dynamics and Control
For an in-depth discussion of the value of independence of central banks check out Bandage, M.S. (2021). Why Central Bank Independence Matters. World Bank Research & Policy Briefs. https://documents1.worldbank.org/curated/en/284641638334557462/pdf/Why-Central-Bank-Independence-Matters.pdf
A full overview of the digital yuan project can be found in Fullerton, E., & Morgan, P. (2022). The People's Republic of China's Digital Yuan: Its environment, design, and implications. https://www.adb.org/publications/the-peoples-republic-of-chinas-digital-yuan-its-environment-design-and-implications