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Institute of Financial Science and Technology, Renmin University of China: what is the impact of CBDC on monetary policy?

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At present, the literature on CBDC, especially the issues related to monetary policy, is still lack of review. The article “Central bank digital currency and monetary policy: a literature review” discusses the hypothetical challenges that the emergence of CBDC brings to monetary policy strategies, implementation and the impact on the macro-economy. The content of the article was compiled by the Institute of Financial Science and Technology of Renmin University of China.

  1. Introduction.

In recent years, the development of payment innovation has been accelerated. These innovations focus on private funds denominated in currencies backed by central banks, as well as virtual currencies without any entity support, or rather, tools to encrypt assets (ECB 2019). The latter has the advantages of technological innovation (distributed ledger technology, including blockchain), but also has the disadvantage of increased volatility. This has contributed to the development of stable currencies linked to one or more global currencies or a valuable asset (BIS 2019). However, stable currencies share challenges with virtual currencies, such as regulatory, legal and security risks, as well as obstacles to monetary policy transmission mechanisms (which may be similar to economic dollarization), threatens financial stability and monetary and duration mismatches on household and corporate balance sheets and bank disintermediation. Most importantly, stable currencies, especially globally, could lead to increased volatility in international financial markets and a decline in the global supply of high-quality liquid assets, which could make it more difficult for commercial banks to meet Basel III standards (BIS 2019). Most importantly, however, stabilizing the popularity of money may challenge the applicability of current payment system solutions.

In order to ensure greater payment security and financial system stability, some central banks are considering providing solutions for individuals that allow them to trade with funds ultimately supported by the central bank (banks BIS 2018, Adrian and Mancini-Griffoli 2019). So in the mid-2010s, they began to consider issuing their own digital currency, a digital version of cash stocks (Barrdear and Kumhof 2016).

This concept is quite novel and loosely structured, which is reflected in the various designs proposed by central banks. However, CBDC has three prominent features. It will be legal tender, can only be used in digital form, and will be issued by the central bank. Most proposals suggest that the number of CBDC will be very limited, at least initially (Barrdear and Kumhof 2016, BIS 2018, ECB 2019). However, if cash is completely eliminated and CBDC becomes the only central bank currency, further research is needed (Borio and Levin 2017, Davoodalhosseini 2018).

The purpose of this paper is to summarize the lack of literature on CBDC, especially the issues related to monetary policy. This paper discusses the hypothetical challenges brought by the emergence of CBDC to the monetary policy strategy, implementation and the impact on the macro-economy. As the current discussion on CBDC is mainly focused on the central banks of developed economies, this paper focuses on the perspective of some emerging market economies, which are almost non-existent in the literature.

The rest of this article is organized as follows. Section 2 outlines the current situation of the central bank’s work on CBDC and the design of CBDC. Section 3 assesses the impact of the emergence of CBDC on monetary policy strategy and implementation, depending on the design chosen. Section 4 is summarized.

  1. The work of the digital currency of the central bank and its design.

According to a survey by the Bank for International Settlements ((BIS)), which surveyed central banks in countries that together account for 90 per cent of global GDP at the end of 2018, about 70 per cent of central banks are studying the concept of CBDC, and the proportion of these banks is rising. However, only 15 per cent are seriously considering issuing any form of CBDC; in the next few years. Due to legal restrictions, 75 per cent of central banks may not be able to issue CBDC banks (Barontini and Holden 2019).

The scope of research on CBDC is purely hypothetical in most cases (Mancini-Griffoli 2018, BIS 2018), with slightly more than 60% of central banks currently in the research stage. About 30 per cent of them are already in the process of testing, and about 10 per cent have launched pilot projects such as Barontini and Holden 2019. A recent example is the people’s Bank of China, which has issued DCEP. Canada or Singapore are developing CBDC wholesale (Bank of Canada 2018, Monetary Authority of Singapore 2017). Meanwhile, nearly 90 per cent of central banks are considering providing CBDC, to the general public as the ultimate goal of their projects, according to a BIS survey.

Most central banks will provide secure and / or efficient payment systems as their main means of motivation after launching CBDC projects. This motivation is highlighted in individual reports by central banks on the progress phase of CBDC research: (Sveriges Riksbank 2017, Sveriges Riksbank 2018, Norges Bank 2018).

Demand for CBDC in advanced economies does not seem particularly urgent. Cash is still a popular method of payment, and the regulatory framework for digital payments is also strong, driven by the central bank (ECB 2019, Danmarks Nationalbank 2017). However, as Lowe points out, in less developed emerging market countries, due to the lack of adequate infrastructure in the first place, innovative payment solutions can play a leading role in payment services in addition to central bank regulation. In fact, they can distort the financial system, monetary policy implementation and interest rate transmission mechanisms, as reflected in the coercive motives associated with these areas in these economies. In addition, emerging market economies mention that reducing the size of the shadow economy is another important motivation behind CBDC’s work, (Barontini and Holden 2019).

Judging from the existing literature, there are great differences among central banks about what CBDC should be. Like BIS (2018), Mancini-Griffoli (2018), Den norske Bank (2018) and the Bank of Sweden (2018), the department is concerned about but not limited to the following standard: (i) availability (applicable only to financial institutions or the general public), (ii) technology (account-based or value / logo-based), (iii) remuneration (interest bearing or not).

In many economies, the development phase of the CBDC version, also known as wholesale CBDC, which is open only to financial institutions, is quite advanced. This version of CBDC is just a technological advance. Under such a framework, if the central bank stops acting at this stage, the monetary policy strategy and implementation will not change. However, as highlighted above, most central banks believe that CBDC will eventually be open to the public. In this case, the central bank is just another commercial bank (Lowe 2017, Danmarks Nationalbank 2017) with strong market forces, which could potentially lead to conflicts of interest between monetary policy or financial stability and commercial activities. If companies were also allowed to open accounts with central banks, the idea would be similar to the inefficient single banking system in the pre-1990 communist Central and Eastern European economies (Racocha 2004, Rod 2014, Szpunar 2018), even if the form was very narrow and limited to deposits. At the same time, commercial banks have stronger expertise in providing deposits and risk management associated with these services (Den norske Bank 2018).

This retention is particularly effective when the CBDC is designed to be account-based or registered and held by individuals with the central bank, as recommended by the Swedish central bank (Sveriges Riksbank) (in 2017 and 2018. In accordance with the regulations of the Norwegian Central Bank (2018), the Swedish Central Bank (2017) and the Bank for International Settlements (2018), in account-based systems, financial assets will be kept in a central system, preferably in a central bank or in a system directly or indirectly controlled by the central bank. As a result, any transaction by an individual will cause a change in the central bank’s balance sheet, which needs to be adjusted, thus complicating the central bank’s balance sheet management policy.

The alternative to account-based systems is the value-or symbol-based system (Sveriges Riksbank 2017, Lowe 2017). In this system, the public can access CBDC through payment tools rather than accounts. The most common solution is that users can withdraw deposits from commercial banks through an application, which is similar to the existing traditional solutions. The Norwegian central bank (2018) believes that there will be little change in monetary policy under such a system, as the balance sheet of the central bank will not be directly affected. The system is also known as the “two-tier” CBDC, because CBDC will still be open to the public through the financial sector. At present, central banks that are considering introducing their own digital currency are increasingly leaning towards value-based CBDC.

However, when it comes to issues related to monetary policy, the most important difference between CBDC is whether account-based CBDC will be paid. The answer to this question will determine the impact of its introduction on the effective floor and indirectly determine the inflation target level, which will be discussed in the next section.

  1. The impact on the strategy and implementation of monetary policy.

The introduction of CBDC alone will have an impact on the overall implementation of monetary policy, even in the long run, the central bank should ensure that CBDC, like cash today, is a neutral and autonomous factor in monetary policy.

According to the consensus in the literature, the greatest impact on monetary policy will be the account-based CBDC available to the public. This is because, as mentioned above, value-based systems and solutions limit the provision of CBDC, to commercial banks, which will be a technological change in the current payment system. At the same time, because of the account-based system, CBDC will have to set conditions for publicly operating accounts to compete with those offered by commercial banks.

The discussion in the literature focuses on the impact of the introduction of CBDC on the lower limit of effectiveness, which varies greatly according to the remuneration of the CBDC account.

If the CBDC account does not bear interest, then as long as the policy interest rate is significantly higher than zero, CBDC will only be an autonomous factor in monetary policy. Once the central bank tries to cut interest rates below zero and commercial banks try to pass them on to subsidiaries, that will change. With the cost of holding CBDC close to zero, deposit holders are likely to transfer to the central bank’s CBDC account. As a result, the situation will be different now, when there may be small negative interest rates because of the costs associated with holding cash. This means that the introduction of interest-free CBDC will increase the effective floor, thus reducing the space for monetary policy regulation. This conclusion is adapted to the concept of liquidity trap put forward by Keynes (1934).

Raising the effective floor to zero has a further important impact not only on interest rate setting itself, but also on monetary policy communication. As the Norwegian central bank (2018) points out, the central bank’s ability to influence expectations, such as forward guidance, will be weaker than it is now.

If the CBDC account is paid, the CBDC rate will constitute the lower limit of the policy rate. While cash is still available, the lower limit of validity will remain basically unchanged. It is still the rate of return on cash, that is, slightly below zero (Barrdear and Kumhof 2016). As the role of cash weakens, the effective floor may even fall, as it is easier for central banks to set interest rates to affect the economy through CBDC interest rates, thus increasing monetary policy space (Sveriges Riksbank 2018). The effective floor may even be removed along with cash, allowing unlimited monetary policy space, prompting the central bank to lower its inflation target (Bordo and Levin 2017).

Although this view is not consistent with the consensus in the literature, it seems that the value-based CBDC will also be affected by the effective lower bound. However, size and direction change over time. Initially, due to technological changes, the holding and transaction costs of CBDC may be high, so the lower limit of effectiveness may even fall. However, as technology becomes cheaper and more widespread, the lower limit of effectiveness is likely to rise. Since it is assumed that the value-based CBDC is not affected by interest rates, in the long run, the lower limit of effectiveness may even be close to zero, so it is higher than it is now.

As long as cash is in circulation, the popularity of CBDC may actually help reduce policy space (Norges Bank,2018). This is because the increased risk of financial stability has led to an increase in risk premium by (Danmarks Nationalbank, 2017). In addition, a decrease in deposits held by commercial banks may lead to an increase in wholesale financing and mortgage-based central bank financing, thereby raising interbank market interest rates and risk premiums (Mancini-Griffoli et al.), respectively. 2018).

The literature also takes into account the further monetary policy tools brought about by the emergence of CBDC.

The first proposal concerns the spread between the CBDC interest rate and the central bank reference rate. According to the Norwegian central bank (2018), under normal circumstances, this spread should remain the same and should be large enough, for example, to insulate CBDC demand from interest rate decisions so that the digital version of cash is neutral. However, in special cases such as a rapid rise in cash demand, spreads are likely to narrow.

The second suggestion is to restrict access to CBDC, mainly to avoid buying the currency for speculative motives. However, Sveriges Riksbank (2018) believes that restrictions may lead to a reduction in the efficiency of the payment system. More importantly, in this case, it is difficult for the renminbi to keep parity with cash. As a result, the (Sveriges Riksbank) of the Swedish central bank is considering imposing a fee on CBDC as an alternative to quantitative restrictions. This concept is not new. Agarwal and Kimball (2015) proposed to abandon the parity between cash and digital currency, on the contrary, to introduce a time-varying banknote deposit fee, thus reducing the lower limit of validity. Therefore, the time-varying relationship between CBDC and cash may be another monetary policy option, but it may raise credibility and practical problems, such as parallel exchange rates.

The existing literature shows that only when CBDC is interest-bearing, can the introduction of CBDC affect the monetary policy transmission mechanism (BIS,2018). Conversely, it is only when interest rates are close to 00:00 that the transmission mechanism is affected (Sveriges Riksbank,2018).

The interest rate channel is the most affected, because the level of CBDC interest rate will have a more direct impact on the deposit interest rate of commercial banks than at present. The impact on bank lending rates and lending channels is generally less obvious, depending on banks’ choice of external sources of capital, rather than a reduction in deposits as a result of the inflow of funds into the central bank. If commercial banks turn to central bank funds, the transmission of central bank interest rates to lending rates may be stronger. However, if banks prefer interbank financing, the central bank may not be able to influence lending rates as much as it does now (Mancini-Griffoli 2018Sveriges Riksbank 2018wonges Bank 2018). It is important to bear in mind, however, that the outflow of deposits from commercial banks and the associated need to provide external funding from different sources do mean that financial stability is challenged and has a potential impact on the efficiency of the overall monetary transmission mechanism (Danmarks National bank, 2017).

Only when non-residents are allowed to use CBDC and decide to use it for speculative purposes will the exchange rate channel of the monetary policy transmission mechanism be affected. However, in the process of flying to safety, the problem will not be limited to a few developed economies. On the contrary, the inflow and outflow of money into and out of CBDC can fluctuate sharply due to different risk preferences, which is likely to be a problem for emerging market central banks most of the time, such as the current situation of other emerging market assets (BIS,2018).

At present, the literature on the impact of the introduction of CBDC on the real economy and inflation is rare, heterogeneous and uncertain. This is because this topic is relatively new, and as discussed above, the construction of CBDC is not yet clear. Therefore, the models used in the existing literature are based on different CBDC concepts, so it is difficult to compare.

The most comprehensive papers on this subject (Barrdear and Kumhof 2016, Davoodalhosseini 2018) are based on the DSGE model, although there are different assumptions. Barrdear and Kumhof (2018) took into account (based on account and interest) the fact that CBDC initially accounted for about 30% of GDP and that cash was still being used. Davoodalhosseini (2018) describes three different primary (and some secondary) scenarios, that is, only cash, only CBDC, cash and CBDC exist at the same time. The latter document also takes into account different forms of CBDC, with particular emphasis on the paid form of the instrument.

Davoodalhosseini (2018) found that the introduction of CBDC may bring welfare benefits, but only if cash is not used at all. The increase in consumption is estimated at 1.6 per cent in the US as the CBDC’s only legal tender is estimated to be 1.6 per cent. Cash and CBDC are available to the public, and monetary policy is found to be more restrictive (due to the existence of an effective floor), yields with high inflation and low benefits. If CBDC is interest-bearing, the result will be improved, but with lower benefits and higher inflation than when there is only one legal tender.

Barrdear and Kumhof (2016) argue that, in turn, the introduction of CBDC could lead to higher production (but also inflation), provided cash is still being used. The decline in real interest rates and transaction costs will have a positive impact. These results are only partially reflected in the more comprehensive report released by the central bank. As noted by the Swedish central bank (Sveriges Riksbank, 2018), CBDC can reduce transaction costs, thereby slightly increasing output, however, it will be offset by financial stability concerns because of capital outflows from commercial banks to CBDC. The decline in real interest rates caused by the model proposed by Barrdear and Kumhof (2016) may simply be due to rising inflation.

  1. Conclusion.

To sum up, the introduction of CBDC is very likely to have an impact on the implementation and transmission mechanism of monetary policy, and even on monetary policy strategies in extreme cases. However, the scale of these effects will depend on the demand for this new form of currency, as well as the design. The impact on the wider economy will be mainly through interest rate channels, especially deposit rates. With interest-bearing CBDC, the effective floor can be kept below zero or even reduced, depending on the popularity of the digital currency. The impact of CBDC on the wider economy will be complex. On the one hand, it should lead to lower transaction costs, which is conducive to higher output and welfare (but also inflation). Lower interest rates will have the same effect, but it is not clear whether the introduction of CBDC will have a net inhibitory effect on them. On the other hand, due to the flow of deposits to the central bank, there are a large number of risks to the stability of the financial system, the most obvious being the risks associated with account-based CBDC.

Research on CBDC and its impact on monetary policy is still under way. Although this innovation is studied from the perspective of the challenges faced by the domestic economy, the research on CBDC from the international level is still relatively insufficient and needs more in-depth understanding.

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