“Smart” monetary policy with the CBDC

The emergence of central bank digital currency (CBDC) is very timely and necessary as the widespread adoption of competing means of payment not denominated in national fiat currencies, such as digital foreign sovereign currency and cryptocurrencies, could potentially jeopardize the ability of the central bank to achieve its monetary objective. political goals.

The CBDC also presents a golden opportunity for a country to improve the effectiveness of monetary policy implementation.

Currently, the effectiveness of central bank monetary policy transmission is sometimes affected by a time lag or less than ideal resource allocation. Economic entities in urgent need of development do not receive the necessary financing and, therefore, their production capacities cannot be expanded. On the other hand, economic entities that are in declining industries may continue to be fueled by funding and survive, or in the case of quantitative easing, excessive funds are drawn in to speculate in stock markets and engender financial bubbles, instead of being deployed to finance productive activities in the real economy. Worse still, it follows with a financial crisis that inflicts enormous suffering on society and the livelihoods of ordinary people and increases wealth and social inequality.

Combining the benefits of traceability offered by blockchain technology and the programmability of smart contracts that would be self-enforced on the blockchain, CBDC is currently being actively researched and developed by many countries around the world, has the technical ability to optimize and significantly improve central bank monetary policy transmission, with pre-defined conditions to incorporate forward-looking and counter-cyclical elements.

Basically, central banks can program digital currency with logic so that it can only be spent for a specific purpose. Central banks can precisely control the amount, direction, and intensity of liquidity or money supply flowing to desired industries. This allows industries to reach an optimal level of production based on market demand and reduce the risk of inflation or deflation due to underproduction or overproduction.

Quick and precise implementation of monetary policy

When the interest-bearing CBDC is widely adopted, the interest rate on the CBDC will serve as the primary monetary policy tool. Any changes to the central bank’s policy rate, via the CBDC, could be passed on quickly and more fully to the interest rates faced by households and businesses.

Then monetary policy can be implemented with precision. Depending on its situation and needs, an economy first classifies the categories of industries it wishes to develop and promote. After careful study and planning, CBDCs will be issued in desirable quantities and then scheduled to be designated and labeled in different industry categories. When the central bank issues and the commercial bank grants a loan, the disbursed CBDC must match the category of the economic entity receiving the loan, otherwise it will be invalidated.

With such a system of classified money 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 interest rate adjustment mechanisms. cash supply. The central bank can also predefine clear term conditions by writing computer codes in the CBDC to support or promote specific industries.

Dr. Yao Qian, Director of the Science and Technology Supervision Office of the China Securities Regulatory Commission and former Director of the People’s Bank of China (PBoC) Digital Currency Research Institute, in a China Economic Journal article published in March 2019, suggested that the CBDC can improve the efficiency of monetary policy implementation by programming forward conditions in the CBDC to solve the problem of lag in policy transmission traditional, to ensure that funding is used as intended and government guidelines on interest rates are followed, and finally to counter any cyclical economic cycle effect, as illustrated below.

In period t0, a central bank sets conditions in advance on the time, industry sector, loan interest rate and economic condition in the CBDC design, and the conditions take effect after the CBDC show. In period t1, a commercial bank plans to lend money and reports the loan information to the CBDC system. If the loan information meets the requirements of time, industry sector, and interest rate conditions of the loan set in advance by the central bank, the loan will be approved and the corresponding amount of CBDC will be activated. During period t2, the commercial bank returns the digital currency to the central bank. If the economic situation is normal, the interest rate of the loan will not change. Otherwise, it will be automatically adjusted according to the rules defined in period t0. For example, when the economy is overheating, the loan interest rate will become higher; when it enters a recession, the interest rate on loans becomes lower, effectively serving as a countercyclical mechanism.

The CBDC method of issuance means that the central bank must determine the amount of money during the design phase of period t0. Leveraging digital technologies, central banks can easily obtain, track and monitor historical transaction data throughout the lifecycle of previously issued CBDCs, accurately measure the speed and velocity of currency circulation and combine them with big data technology in the vast collection of payment data. of social and economic entities, in the analysis of the consumption and investment behavior of the private and public sectors, eventually providing a high-quality database for the review and reformulation of monetary policy, including the adjusting the amount of CBDC for each of the industry categories and putting in place the necessary policy incentives targeting specific industry categories.

Negative interest rate

Another advantage of the CBDC is the effective implementation of negative interest rate policy, which enriches the central bank’s unconventional monetary policy toolkit. Under a traditional physical money or cash system, the lowest effective interest rate the central bank can adjust to is zero, because people can convert their deposits to cash to avoid the impact a negative interest rate. Even in the case where cash system and CBDC coexist, for large institutions, holding cash also entails storage, transportation, insurance and transaction costs, etc. The large-scale conversion of deposits into cash depends on the comparison of negative interest rates on deposits and the cost of holding cash. If the negative interest rate on deposits is higher than the cost of holding cash, this will lead to a large-scale shift from deposits to cash. With the CBDC replacing cash, the central bank can break the lower bound of the zero interest rate and effectively enforce a negative interest rate policy by cutting interest rates as much as necessary to avoid a deflationary spiral.

Issues and Risks

With increased speed and speed of circulation of digital currency, a rapid central bank response is needed. This also means that the monetary policy review cycle is likely to shorten.

Technical risks associated with the use of CBDCs that central banks need to monitor include unintended consequences due to design flaws and programming errors resulting in a lack of flexibility and inclusiveness in the conduct of monetary policy.

There are also potential macro-finance issues to address. For example, if people prefer CBDCs to bank deposits because of the higher interest rate offered by interest-bearing CBDCs, or if people flee bank deposits and seek refuge in risk-free CBDCs in times of stress or market crisis, there is an increased risk of disintermediation of the banking sector resulting in a decline in the total amount of deposits and bank loans. Then, the importance of bank credit in the overall transmission of monetary policy will be weakened, and other more important transmission channels will have to be identified.

“Smart” vs. “mechanized” monetary policy

The emergence of programmable money will make it possible in the future to conduct monetary policy in a more targeted, precise and transparent manner. The CBDC is an innovative smart currency that will help strengthen the management of market expectations, improve the efficiency of monetary policy transmission, and ultimately achieve what we might call a “smart monetary policy” which allows an efficient allocation of resources.

On the other hand, with the possibility of pre-defining rules, programmable money also increases the power of the central bank to impose more direct administrative intervention and potentially weakens the role of financial intermediaries in directing the flow of money. . It is therefore important for the central bank to continuously master the full understanding of changing development goals, macroeconomic dynamics and market forces in order to strike a healthy and prudent balance between the market’s ability to self-adjust and direct administrative intervention, thus avoiding excessive or excessive writing. conditions precedent to monetary circulation such as the case of a “mechanized monetary policy“!

China’s journey with the CBDC

China has been working on its CBDC since 2014. In 2016, the PBoC successfully built the digital yuan prototype. In May 2019, China became the first major country to launch a full-scale pilot project for its CBDC in cities including Shenzhen, Suzhou, Chengdu, and Xiong’an. According to a white paper “Progress of Research & Development of E-CNY in China” published by the PBoC in July 2021, the pilot project now extends to the Yangtze River Delta; the Pearl River Delta; the Beijing-Tianjin-Hebei region; and the central, western, northeast and northwest regions of China.

More importantly, in March 2021, China paid wages to builders using its digital yuan known as e-CNY in Xiong’an district in Hebei province. The Xiong’an district government called it China’s first “on-chain” payments used for wages, meaning blockchain technology is used to track and distribute builders’ wages. This is the first “blockchain plus digital yuan” application scenario in China. With its lead in CBDC research and development, it should come as no surprise to see China being one of the first countries to experiment with “smart monetary policy” with the use of programmable currency.

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