Central Bank Digital Currencies: Potential Keys to Global Economic Recovery
Michael Sung / Charles Chang — Fudan Fanhai Fintech Research Center
We live in extraordinary times, where the current COVID-19 epidemic which started at the beginning of 2020 has developed into a global black swan event, causing massive suffering and disruption for societies world-wide. The epidemic exacerbated an already dangerously precarious economy, and has since cascaded into a rolling financial crisis throughout the world that cuts across all sectors of industry and levels of society. If the epidemic persists into the Fall, the unprecedented quarantine measures restricting the movement and activity of people in and between countries could further push many of the world’s economies into collapse.
The extreme quarantine measures have been highly successful in effectively preventing the exponential spread of the disease. However, this has come at a great cost to the world, as the resulting disruption in lost productivity and long-term economic contraction has yet to be fully assessed. China’s PMI (a measure of the prevailing direction of economic trends in manufacturing), for example, has fallen to the lowest levels in recorded history as labor mobility, transportation linkages, supply chains, and retail activity across the country have been forced to shut down completely. Large corporations and SMEs alike have faced bleak prospects, with two-thirds of companies that were surveyed reporting that they have runways of less than just a few months of cash on hand. The imminent and systemic closure of large swathes of the economy combined with the inability to provide credit to the most fragile sectors of society could likely result in the largest economic depression the world has ever seen. Even as the country began relaxing travel restrictions and companies are opening up back for business earlier this month, the full scope of the challenge ahead to stimulate the world’s economic recovery remains an extremely challenging task.
One key potential weapon to allow countries to recover quickly are central bank digital currencies (CBDCs), such as the digital RMB that was announced by the PBOC at the end of 2019. As the world’s first central bank digital currency (CBDC) to be issued by a G20 nation, the digital RMB will instantly become the largest fully fiat-backed digital currency globally. It turns out that the extremely serendipitous timing in the deployment of the digital RMB can give the People’s Bank of China, the central bank of China, powerful new technology-enabled monetary and fiscal policy tools that can be effectively leveraged to stimulate the economy. This reference case could be replicated by other central banks world-wide to help their nations’ leverage their monetary resources more effectively than through traditional means.
The Superiority of a Central Bank Digital Currency
A CBDC represents an electronic fiat liability that a central bank can use to settle payments. This concept of an electronic currency has existed for decades in the form of electronically settled with Real Time Gross Settlement (RTGS) systems that can adjust reserve balances that are held by commercial banks at the central bank. In the case of a CBDC, the central bank may issue fiat money that has the potential to be universally accessible and be used as a means of payment for the general population, not just as a settlement tool for commercial banks. For example, as stated by PBOC, the digital RMB is initially meant to replace the M0 money supply, i.e. notes in circulation and other assets that are easily convertible into cash.
The three hallmarks of a currency are as a unit of account, store of value, and medium of exchange. A digital currency is superior to its physical banknote predecessor as well as related money instruments in each of these critical attributes. Currently, when ordinary people want to use central bank money to store value and medium of exchange, the only available option with no credit risks are paper-based banknotes. Therefore, they bear the costs of handling and storing banknotes safely (e.g. counting cash and depositing in a bank account). As a stable unit of account and store of value, a CBDC represents a secure store of value as it is a fiat issued directly by a central bank, without any of the risk associated with payment platforms from private companies and accounts at banks, all of whom can default in a crisis. As a medium of exchange, a CBDC can be exchanged in a completely friction-free, costless manner as well as exchanged peer-to-peer (e.g. between digital wallets on mobile phones). As a practically costless medium of exchange, a CBDC would significantly enhance the efficient and secure settlement of financial transactions, from retail transactions to cross-border payments.
CBDCs Improve Market Efficiency
A CBDC effectively combines the efficiency of existing forms of digitised deposits with the additional capability for the peer-to-peer transaction of cash. Having a CBDC allows the inclusion of risk-free fiat currency to complete the full digitalisation of money and payments in a country. These economic benefits would become more pronounced if the CBDC is eventually rolled out to encompass bank deposits as well, in which case they could reduce the scale of the commercial banks’ credit intermediation. For example, models developed by the Bank of England have shown that the aggregate effect of CBDC issuance of 30% of the GDP has the potential to permanently raise GDP by as much as 3% due to reductions in transaction costs, real interest rates, and distortionary taxes.
At the same time, the introduction of a CBDC into the ecosystem would provide a necessary alternative system for cashless payments in a country. This would provide banks and other financial institutions to be competitive to participate as alternative financial service providers, which is healthy for the robustness of a diversified payments ecosystem. The resulting financial sector would be more competitive in providing greater benefits to end users. It represents a reorganisation of the existing third-party payment sector to include already-established financial institutions and creates opportunities to effectively monitor and regulate the industry, reducing overall system-wide financial risk. Indeed, with the digitisation of fiat, there are opportunities for synergies with information technologies combining big data analytics and Blockchain. Entire histories for transactions would be available, providing massively more data to policymakers, including the ability to observe bad actors or to measure the economic response to shocks or to policy changes almost immediately. This would provide for significant enhancements to monitoring and regulation in a data-driven and real-time way.
Notably, the payment efficiencies of a CBDC would have the most pronounced benefits for lower-income households and small businesses, the most vulnerable in economic downturns. Lower-income households tend to rely heavily on cash, and small businesses incur substantial costs for handling cash and interchange/exchange fees for processing payments such as via credit and debit cards. CBDCs can be used to support small retail transactions, and as separate and distinct from the nation’s bank deposits, it would be highly effective as a way to provide financial services efficiency and resilience for the underserved. A CBDC could result in the reduction of many transaction costs and would radically increase financial inclusion for the rural and unbanked population by obviating the need of even owning a bank account. Additional opportunities for these constituents include the possibility to hold interest-bearing currency and to have access to micro-loans and credit facilities through online banking. A nation-wide roll-out of a CBDC would cater specifically to these underserved segments of society, notably rural populations.
As such, the introduction of a CBDC would dramatically boost economic growth through efficiency gains and increased productivity from the most fragile segments of the population. Because of the transaction efficiencies, the velocity of money in circulation can be dramatically increased, thereby encouraging consumption and increasing volume of trade and economic activity. The digitisation of fiat currency also allows a larger percentage of the money supply to be accounted for, which in turn would allow for more big data opportunities, such as credit risk analysis for low-default micro-loans. This would result in a large improvement in extending lending and credit facilities for the underserved over the existing system. As example, for many SMEs and private companies, currently the only way to access credit is through the shadow lending market, which is completely nontransparent to regulators and results in layers of middlemen seeking rents at usury rates. The introduction of a CBDC would avoid these credit supply/demand market dynamics that can contribute to systemic crises.
A CBDC can also designed to be pseudonymous (and hence pseudo-private), as is the case with the digital RMB. It is not necessary to require any bank card, linked bank account, or even working internet connection to conduct small-scale CBDC transfers. The digital cash would be held in a purpose-specific digital wallet. This makes it completely fungible and infrastructure-free, in a way unlike all other payment and remittance systems ranging from Alipay to Apple Pay to SWIFT. Again, this allows a CBDC to directly serve those without access to traditional financial services. Larger transactions could require higher levels of KYC/AML verification and could be tracked by monitoring the fiat on-ramps and off-ramps to the accounts/wallets, akin to existing controls in the traditional banking industry. As such, CBDCs can reduce exposure to tax evasion, money laundering, and other illegal activities. In the long run, this would re-directed mis-appropriated money back to the productive economy.
CBDCs as Monetary Policy Tools and Conduit for Quantitative Easing
In addition to the positive impact on payment efficiency, there is strong potential for banks’ fund disintermediation and improving the transmission mechanism of monetary policy, facilitating a systematic and transparent channel for a central bank. This would give a central bank powerful new instruments to conduct monetary policy with more direct connection to the real economy and with much more fine-grain controllability. As a CBDC can be programmable, there are opportunities for digital innovation to enabling brand new forms of smart money. These functions may include various forms of meta-data and information processing that could allow the potential for smart contract-enabled automated execution of transactions. These new types of capabilities can facilitate transactions and efficient interactions much better than the static currencies of today. One such innovation is an interest-bearing CBDC, which could provide a truly secure store of value. This type of CBDC functionality could be distinct from and non-substitutable with bank deposits, providing an alternative policy tool for efficient deployment of monetary and fiscal policy. Such a tool could also be used as a stabilisation measure for business cycles by controlling either the quantity or the price of digital currency in a counter-cyclical fashion.
There have long been strong arguments made by various economists that government-issued money should ideally bear the same rate of return as other risk-free assets in order to be a more useful medium of exchange. Implementation of these concepts was impossible with traditional paper banknotes, so modern money has been designed to steadily deflate rather than maintain true price stability. With a digital currency, a central bank could create a truly stable store of value that would not lose value over time due to inflation. An appreciating/interest-bearing CBDC could provide the ultimate stable unit of account and secure store of value which would facilitate it as a globally recognised medium of exchange. The real value of a CBDC could be held stable over time relative to a price index/CPI basket, resulting in a new instrument with fundamental purchasing power stability.
Targeting true price stability would be substantively different from the current practice of inflation forecast targeting. Currently, monetary policy by most central banks around the world consists of aiming for positive inflation rates targets of around 2% or so. In the wake of the global financial crisis, some economists have advocated even raising those targets to provide more room for monetary policy flexibility. The lower bound on nominal interest rates has been a primary motivation for maintaining such a positive inflation buffer. With an interest-bearing CBDC, there would no longer be a compelling need to maintain any inflation buffer since a central bank could directly realise purchasing power stability. Thus, an interest-bearing function would contribute to greater macroeconomic stability.
Furthermore, when circumstances call for Quantitative Easing (QE), which has been widely discussed/deployed during the COVID-19 Crisis, CBDCs also have the potential to provide direct transmission of monetary and fiscal policies, with the ability to selectively bypass inefficient credit intermediation of banks. Since the Credit Crisis of 2009, massive quantitative easing stimulus plans across the major global economies resulted in inefficient allocations of credit that were of limited impact in stimulating real economic growth. QE was directed through banks, so the benefit of the stimulus accrues inequitably to the institutions that have access; namely the banks, state-owned enterprises, and large corporations. Furthermore, in that instance, capital was directed to banks because the root of the Crisis was ostensibly in the solvency of banks and the confidence of investors in the stability of the financial system. The Crisis was viewed as having started in the investment and poor operating behavior of the financial sector, which in turn impacted the real economy.
QE sought to fill bank reserves and re-establish trust in the solvency of the banking system. Even so, in the U.S., exclusive access to easy credit by the top 1% of society has drastically exacerbated income inequality, destabilising society. Banks and corporations have used this easy credit to systematically initiate massive stock buy-backs, essentially leveraging accounting tricks that consolidate wealth in the hands of company executives and equity holders but do not translate into more real growth in the economy. This has resulted in rampant stock and bond market excesses that are now rolling into the end of the current long-term debt cycle which is now causing the systemic crash in the markets as we speak. As example, the U.S. airline industry spent $39B in government stimulus for stock buy-backs since the 2008 crisis, and now is asking for another $50B bailout as they face bankruptcy because worldwide travel has halted from the COVID-19 pandemic.
In the COVID-19 crisis, the root of the downturn lies in a global slowdown in economic activity not silo-ed within a particular industry or country. It has impacted the real economy directly by destroying consumption, corporate earnings, wages, and employment rather than through the financial system. As a result, funding a particular industry or a small number of large banks or corporations will not likely lead to an effective, speedy recovery. Here, the ability of governments to provide funding directly to businesses and individuals is critical. CBDCs provide an opportunity for the government to directly stimulate consumption through quantitative easing targeted to individual households. It is estimated that in the U.S., 40% of Americans would struggle to pay an unexpected $400 USD expense due to limitations in available cashflow and financial planning. The U.S. government is now considering an emergency bill to distribute U.S. citizens $1000 USD as essentially a universal basic income-style subsidy.
Similar relief programs can be used to provide operational funding and credit to businesses. The programmable functionality of CBDCs could facilitate the provision of credit subsidies or cash relief to existing loans. Stimulus funds could be deposited directly into CBDC accounts/wallets of vulnerable SMEs, thereby cushioning the effects of a downturn. Conversely, it could be programmed with restrictions for non-desired use cases, such as real estate speculation, P2P lending, or corporate stock buybacks. This would direct funding to properly stimulate the economy as intended. In the United States, a program was proposed to Congress during the COVID-19 Crisis that included the use of digital dollar to deliver cash stipends directly to citizens in need. In that particular bill, funds direct deposited into digital wallet issued to citizens was included as an alternative to traditional checks. In contrast, indirect stimulus would have to trickle down from the central bank to policy banks, to commercial banks, and finally to companies, individuals and SMEs. At each stage, the capital faces potential losses from transactions costs, from the inability to effectively deploy, from inefficiencies in allocation of capital to enterprises or persons who do not need it, and from time wasted. Direct-to-recipient stimulus avoids all of these costs.
Indeed, an interest-bearing CBDC could serve as alternative tool of monetary policy, thereby mitigating the need to deploy more brute-force monetary techniques such as quantitative easing or other direct fiscal interventions. This would allow households and businesses to have better visibility and ability to properly forecast their costs across long periods of time. Again, such stability could be particularly beneficial for lower-income households and small businesses, which typically have limited access to sophisticated financial planning advice or complex financial instruments that can help hedge against such inflationary risks. The monetary and fiscal policies conducted in this way would be more straightforward, systematic, and transparent, resulting in greater financial stability of the overall monetary system.
The launch of the digital RMB by China has rapidly accelerated the serious discussion and testbeds of similar CBDCs by central banks around the world, something unthinkable just a year prior. Given all the compelling advantages outlined above, CBDCs represents potent tools for a country’s recovery from the concurrent COVID-19 epidemic and global economic crises challenging the world today. In addition, CBDCs could massively drive the future of the digital economy by catalysing the adoption of regulated digital assets around the world as well. In our next article, we will focus on what this exciting future world of digital assets will look like. Until then!
About the authors
Professor Charles Chang is the Deputy Dean of Academics, Professor of Finance, Director of the Fintech Research Center, Fanhai International School of Finance. Member of the finance faculty at the Chinese University of Hong Kong.
He was a faculty member at the Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University. He was a visiting professor for National Taiwan University and Peking University. Prior to returning to Asia, he spent six years on the professorial faculty at Cornell University.
Professor Chang’s research spans the fields of Fin-tech, investments, corporate finance, and behavioral finance with a focus on emerging markets. He has ever won the National Merit Scholar in United States of America. His work has been noted in more than 200 media outlets with work published in top journals such as the Journal of Financial Economics, the Journal of Corporate Finance, the Journal of International Money and Finance, the Journal of Banking and Finance, Journal of Derivatives forthcoming and Financial Management.
Professor Chang established the Fintech Research Center (FRC) in 2018. He led the team co-hosted the Forum “The future of Fintech” with Sustainable Development Group of the United Nations on The World Economic Forum at Davos, Switzerland in January 2019. In April 2019, FRC co-organized the forum “Future of Money 2019: Brilliance in Fintech” with The Swiss Federal Government and Oriental Securities Co., Ltd. The Swiss Federal President and Finance Minister, Mr. Ueli Maurer participated the event with his finance and economic delegation.
His main teaching interest is Fin-Tech, Investment, Corporate finance. Professor Chang was a decorated scholar at the University of Pennsylvania where he earned Bachelor degrees in electrical engineering and finance at the Wharton School, in 1998. Then, in 2003, he received a PhD in Finance from the Haas Business School at the University of California, Berkeley.