A justification for introducing Central Bank Digital Currencies (CBDCs) has been to safeguard countries against the loss of monetary sovereignty, particularly currency substitution (when foreign monies displace domestic currencies) which could undermine the ability to effectively conduct monetary policy and the central bank role of being lender of last resort (LLR) to the financial system.
This paper looks at the implications of currency substituting that go beyond the functions of central banks, to consider the key differences in monetary policy and LLR, particularly variations in and consequences of degrees of monetary sovereignty, and to assess the implications and risks of currency substitution and how they vary between countries.
Summary of key points
Theoretically digitalisation of money expands the supply of attractive and accessible currencies. It provides people with the ability to access money for transactions and/or store of value perhaps separate from their immediate domestic situation. It increases the chances of people choosing to substitute their domestic currency for something different.
The ability of a central bank to implement monetary policy and to be the LLR, depends on is exchange rate regime and the extent to which the public and private organisations borrow using the domestic currency. Depending where a country sits on the spectrum determines how much countries have to lose from currency substitution.
If monetary policy is well managed, then this removes a key driver for people and organisations to substitute their local currency, however, if there is domestic monetary instability, particularly high levels of inflation, the risk increases. The paper identifies a subset of Emerging Market and Developing Economies (EMDEs) in this category.
National currencies can fulfil a range of roles beyond those relating to monetary policy and the LLR function, fostering a sense of national identity, reinforcing boundaries of national economies and bolstering state revenues. These can play an important role in central bank considerations about how to react to the digitalisation of money.
GSC and foreign CBDCs: a new source of currency substitution?
The risk of currency substitution is higher because if;
Big tech companies introduce Global Stablecoins (GSCs). The network effect of ecommerce and social media technology companies could allow them to achieve high numbers of users quickly across the world. In effect they could create ‘digital currency areas’ (DCAs) based on their reach. Similarly, the introduction of a CBDC by a major economy could have a similar effect. China’s e-yuan being the most immediate example.
Switching costs may fall because it will be easier to calculate prices and convert balances between currencies. Combined with easy access through apps, moving money into GSCs or CBDCs may be straightforward and within reach of anybody who can go online.
Digital currencies should be capable of doing more than cash. Concepts such as programmable money, smart contracts, interoperability with other financial services and privacy open up opportunities. Some digital currencies may be designed as mediums of exchange, others for the store of value. This benefit may make digital money attractive even in countries that have domestic monetary stability.
Implications beyond monetary policy and LLR
Currency retains a hugely important symbolic function. It also is a source of seigniorage generating revenue for governments. While this may be relatively unimportant compared with other revenue streams, in many countries seigniorage provides central banks with funding independent of the government. This helps protect central banks from the politicisation of monetary policy. Finally, currency creates an economic ‘geography’, effectively defining a market creating patterns of economic activity across physical and virtual spaces driven by transaction costs. Low transaction costs create more integrated national markets and reinforce their boundaries.
Digital currencies could create DCAs that reorientate markets away from being national to regional, although this integration also brings risks of divergent regulatory and technical standards that may also create wider market fragmentation. This underlines the need for new global standards to be developed.
Cross-country differences in monetary policy and LLR capabilities
The state is the only entity that can settle its debts by issuing more of its own liabilities and cannot, therefore, default on its debt obligations if they are denominated in its own currency. This allows it to stabilise its financial system in an emergency. Its ability to do this is limited by the extent to which the country has a fixed compared with a floating exchange rate and the extent to which the government and private sectors borrow in the domestic economy.
Where exchange rates are fixed to an external anchor, monetary policy is forfeited. Foreign debt also means financial stability is at risk since monetary policy is, effectively, outsourced. The ability of a country to pursue a monetary policy depends where it sits on a spectrum of sovereignty.
The paper explains how the US, the Eurozone and China are all exceptions, albeit for different reasons (global currency, strong monetary policy and LLR collective capability although individual states have little to none, exchange rate management based on capital controls and low levels of foreign currency debt respectively).
Uneven risks of currency substitution
The size of the monetary policy performance gap between the domestic currency and the alternatives is likely to be a major determinant of the level of currency substitution. Around the world about a third of countries are substantially dollarized – over 30% of deposits and loans being held in foreign currency. Foreign currency accounts for more than half of total deposits in 17% of countries and over half of total loans in 11% (IMF 2020).
Importantly, all of these countries are EMDEs that have struggled with monetary instability, and the paper argues that it is the EMDEs who face the highest risk of currency substitution.
Implications and conclusions
CBDCs may be a useful defence response against the risk of digital money disrupting monetary policy and the LLR function for countries with a relatively strong monetary system even though their risk of currency substitution is low. In these countries the CBDC will need to be designed to ensure they are a good alternative to the benefits offered by digital currencies (smart contracts etc.).
For countries concerned about monetary sovereignty, the rate of development and issue of digital currencies may affect the timing and sequence of the launch of their CBDCs as a defence and response to what others do. They could respond, of course, by using regulations to limit the use of GSCs and foreign CBDCs in their economies. If digital currencies are widely issued, then countries will need to consider domestic needs and the international effects of policies, ideally co-ordinating against arbitrage and the fragmentation if the international monetary system.
In countries with poor macroeconomics and financial issues, CBDCs do not fix these problems and so they will offer a weak defence.
If countries are driven by an internal logic, for example extending financial inclusion, then their decision to issue a CBDC will move at their own pace rather than being externally driven.