Dr. Pei Sai Fan, Formerly Director of MAS Academy

Dr. Pei Sai Fan, Formerly Director of MAS Academy

CBDC enables ‘smart’ monetary policy

The innovative currency will help strengthen management of market expectation, improve efficacy of monetary policy transmission for efficient resource allocation.

THE effectiveness of a central bank’s monetary policy transmission is sometime affected by time lag or less-than-ideal resource allocation. The economic entities in urgent need of support are not given the required funding and hence their production capacities cannot be expanded. On the other hand, economic entities that are in sunset industries may continue to be fed with funding and survive, or in the case of quantitative easing, excessive monies are attracted to speculate in stock markets – which engender financial bubbles – instead of being deployed into productive activities in the real economy. Worse, this results in financial crisis that inflicts enormous pain for society and disrupts the livelihood of ordinary people, widening wealth and social inequality.

Digital cash – specifically central bank digital currency (CBDC) – can help enhance the system. Combining the advantages of traceability offered by blockchain technology and the programmability of smart contracts which would be self-enforced on blockchain, the CBDC now being actively researched and developed by many countries around the world has the technical capability to potentially optimise and vastly improve the central bank’s monetary policy transmission, with preset conditions to incorporate forward-looking and counter-cyclical features.

Basically, central banks can programme digital currency with logic so that it can be spent only for designated purposes. Central banks can accurately control the amount, direction and intensity of liquidity or money supply flowing to the desired industries. This allows industries to achieve an optimal level of production based on market demand and reduce the risk of inflation or deflation due to under- or over-production.

First, based on its own circumstances and needs, an economy clearly classifies the categories of industries it wants to develop and promote. After careful study and planning, the CBDC will be issued and then be programmed such that it is designated and tagged to different industry categories. When a central bank issues digital currency or a commercial bank makes a loan, the CBDC disbursed must correspond to the category of the economic entity receiving the loan, or it will be rendered invalid.

With such a system of classified currency issuance and credit creation, the central bank can implement targeted monetary policies for different industries with different statutory reserve ratios, interest rate adjustment mechanisms, and liquidity supply mechanisms. The central bank can also preset clear forward conditions by writing computer codes into the CBDC to support or promote specific industries.

ADDRESSING THE ISSUE OF TIME LAG

In a journal paper published in March 2019, Yao Qian, director of the Science and Technology Supervision Bureau of China Securities Regulatory Commission and former director of the Digital Currency Research Institute at People’s Bank of China, suggested that CBDC can enhance the effectiveness of monetary policy implementation by programming forward conditions into CBDC to address the issue of time lag in traditional policy transmission, to ensure funding is used as intended and the government guidance on interest rates is followed, and finally, to counter any economic cyclical effect, as illustrated below.

In the T0 period, a central bank sets forward conditions on time, industry sector, loan interest rate, and economic state in the CBDC design, and the conditions become effective after the issuance of CBDC. During T1, a commercial bank plans to lend money and report the loan information to the CBDC system. If the loan information meets the requirements of the time, industry sector, and loan interest rate conditions set by the central bank in advance, the loan will be approved and the corresponding amount of CBDC will be activated. During the T2 period, the commercial bank returns the digital currency to the central bank. If the economic situation is normal, the loan interest rate will not change. Otherwise, it will be automatically adjusted according to the rules set in the T0 period. For example, when the economy is overheating, the loan interest rate will become higher; when it enters a recession, the loan interest rate will become lower, effectively serving as a counter-cyclical mechanism.

The issuance method of CBDC means that the central bank must determine the amount of money during the design phase in the T0 period. Leveraging on digital technologies, central banks can easily obtain, track and monitor historical transaction data in the entire life cycle of CBDC previously issued, accurately measure the speed and velocity of currency circulation, and combine with big data technology in the extensive collection of payment data of social and economic entities, in analysing consumption and investment behavior of the private and public sectors, eventually providing a high-quality database to review and reformulate monetary policy including adjusting the amount of CBDC for each industry and putting in place the necessary policy incentives targeted at specific industries.

Another advantage of CBDC is the effective implementation of the negative interest rate policy, which enriches the central bank’s non-conventional monetary policy toolbox. Under traditional physical currency or cash system, the effective lowest interest rate the central bank can adjust to is zero, because people can convert deposits into cash to avoid the impact of negative interest rate. For large institutions, holding cash also incurs storage, transportation, insurance, and transaction costs, et cetera.

Whether there will be large-scale conversion of deposits into cash depends on the quantum of both the negative deposit interest rate and cost of holding cash. If the negative deposit interest rate is greater than the cost of holding cash, it will cause a large-scale transfer of deposits into cash. With CBDC replacing cash, the central bank can break the zero-interest rate lowest limit and apply negative interest rate policy effectively by reducing the interest rate as much as needed to avert a deflationary spiral.

TARGETED, PRECISE, TRANSPARENT

In short, the emergence of programmable money will allow conduct of monetary policy of the future to be more targeted, precise, and transparent. The CBDC is innovative smart currency which will help strengthen the management of market expectation, improve the efficacy of monetary policy transmission, and finally achieve the “smart monetary policy” that brings about efficient resource allocation.

On the other hand, with the ability to preset rules, the programmable money also increases the central bank’s power to impose more direct administrative intervention and potentially weaken the role of financial intermediaries in directing how the money should be circulated. It is therefore important for the central bank to continuously master the full understanding of the economic development and market forces to strike a good and prudent balance between the market’s self-adjusting ability and direct administrative intervention, avoiding excessive or overly writing of pre-conditions for money circulation, avoiding what might become “mechanised monetary policy”.

In addition, with higher speed and velocity of digital currency circulation, the central bank’s quicker response is required, which means the review cycle of monetary policy will become shorter. Other risks of using CBDC that central banks should watch out for include unintended consequences due to design faults and programming errors resulting in lack of flexibility and inclusiveness in the conduct of monetary policy.

In March 2021, China disbursed wages to builders using its digital yuan known as e-CNY in Xiong’an district in Hebei province. The Xiong’an district government called this China’s first “on-chain” payments used for wages, which means blockchain technology is used to keep track of and pay builders’ wages. This marks China’s first “blockchain plus digital yuan” application scenario. With its leading edge in the research and development of CBDC, it should be no surprise to see China being one of the first few countries to experiment on “smart monetary policy” using programmable money.

The original article was published in <The Business Time> on OCT 07, 2021.

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