The data collected through CBDCs has the potential to be paired with strict reserve requirements for commercial banks, creating a theoretical framework for inflation control
The worldwide severe inflation surge can be attributed to a complex and protracted series of events initiated by the COVID-19 pandemic in 2020 and exacerbated by the Russia-Ukraine conflict in 2022. This inflationary challenge continues to persist. Throughout this extended duration, policymakers and central banks around the world have faced a consistent challenge: Reigning in inflation. The prevailing strategy has involved rapidly and decisively raising interest rates to moderate economic growth and curb the upward trajectory of prices. In such a scenario, could central bank digital currencies (CBDC) offer a solution?
The upcoming 22 October presidential election in Argentina carries notable economic consequences. Sergio Massa, who serves as both the Minister of the Economy and as presidential candidate representing the Union for the Homeland party, has pledged to implement a CBDC. This initiative comes at a time when Argentina has been grappling with persistent hyperinflation, placing monetary policies at the centre of election discussions.
The prevailing strategy has involved rapidly and decisively raising interest rates to moderate economic growth and curb the upward trajectory of prices.
Massa has made it clear that launching an Argentine digital currency will be a top priority should he win the elections and become the country's next president. Massa emphasised that this move aligns with the platform's goal of facilitating economic transactions via mobile phones or cards, ensuring accessibility for all of Argentina. He further outlined that this digital currency would be accompanied by a law allowing individuals abroad to repatriate and use funds without incurring additional taxes. Massa also promised that users conducting economic transactions with the Argentine digital currency would receive a tax reduction. Well-designed CBDCs have the potential to enhance payment system convenience, flexibility, and efficiency, contributing to increased financial inclusion, especially in Latin America and the Caribbean. However, despite his promises, the timeline for implementing a CBDC in Argentina remains uncertain if Massa wins the election. Currently, the country is in the research phase on CBDCs, with political discussions on the topic gaining momentum during the election campaigns. Conversely, Massa's primary opponent, Javier Milei from the Libertarian Party, supports an alternative approach. Milei advocates dollarisation—dissolving the central bank, ditching the peso, and adopting the US dollar to combat inflation. Critics doubt this due to Argentina's limited central bank reserves and past failed dollarisation attempts. They also face repaying a substantial International Monetary Fund (IMF) loan. Milei's team, however, argues that Argentines have substantial foreign savings, supporting dollarisation. Their plan involves a Monetary Stabilisation Fund replacing the central bank overseas, facilitating debt repayment. This might constitute Argentina's most substantial debt reduction without resorting to default.
Milei advocates dollarisation—dissolving the central bank, ditching the peso, and adopting the US dollar to combat inflation.
This divergence in economic strategies highlights the significant choices Argentina must make in the forthcoming election. Solving Argentina's inflation challenge remains a puzzle, nonetheless, the CBDC scenario offers an intriguing possibility. Delving into the potential of CBDCs in inflation management is essential, especially given that most central banks are navigating uncharted waters in this regard.
One possible explanation is that having more data can lead to better policy decisions. As central banks globally raise policy rates, there is an increasing risk of synchronised recessions. A common challenge central banks have grappled with during this period of inflation is the lack of data. They've encountered difficulties in analysing their respective economies, especially when it comes to inflation rates and the impact of policy rate hikes on the real economy. However, CBDCs can provide both data and policy tools to significantly mitigate this risk. Numerous Consumer Price Index (CPI) reports across the globe rely on data measured in a way where asset and liability information gets submitted by market participants to central bank regulators. This data, unfortunately, tends to be outdated, occasionally lacking in completeness, and regrettably prone to inaccuracy. Transforming this information into a meaningful index of price inflation or financial risk entails substantial guesswork for central banks. Statistical modelling of the ripple effects of inflation or financial stress encounters hindrances due to the lack of transparency in much of this data. CBDC architecture offers an alternative and innovative approach. It equips central bank economists and regulators with a wealth of near real-time information regarding CBDC balances held by financial institutions. It also includes metadata that can categorise which industry each CBDC transaction relates to, enabling real-time CPI measurement and more effective inflation management, all while maintaining the privacy of transaction details for all users. In this system, central banks don't need to rely on institutions to report their CBDC assets and liabilities; instead, central bank staff can directly query CBDC balances.
Statistical modelling of the ripple effects of inflation or financial stress encounters hindrances due to the lack of transparency in much of this data.
Exploring the dynamics of money supply and the potential impact of CBDCs on the economy is an intriguing endeavour. There are interesting plans being proposed in Europe for the utilisation of CBDCs to manage inflation and debt effectively. CBDCs possess unique characteristics that can be leveraged to exert control over inflation and influence the money multiplier effect. In contrast to conventional fiat currencies, CBDCs are digital in nature and can be subjected to various customisable reserve requirements stipulated by the central bank. One notable requirement under consideration is the imposition of a 100-percent reserve rule. This mandate would necessitate that commercial banks hold an equivalent amount of CBDCs in reserve for each unit they lend or create as money. The introduction of such a reserve requirement carries significant implications for the money multiplier effect. In a fractional-reserve banking system, where banks can re-lend a portion of deposited funds to generate additional money, the money multiplier is typically greater than one. However, by implementing a 100-percent reserve requirement on CBDCs, central banks can effectively curtail the ability of commercial banks to multiply CBDCs, thereby, mitigating inflationary pressures on the economy. One approach to achieving this goal involves reducing the circulation of traditional currency by the central bank selling government bonds. Concurrently, the introduction of digital currencies, such as CBDCs, augments the money supply. This strategic exchange shifts the money multiplier from its customary position of more than one, as observed in fractional-reserve systems, to a level of one or close to one.
In a fractional-reserve banking system, where banks can re-lend a portion of deposited funds to generate additional money, the money multiplier is typically greater than one.
It's important to consider that there exist middle-ground strategies as well, such as adopting a less rigid reserve requirement to harness some advantages of the proposed system. Additionally, following the CBDC transition, reserve requirements could be slowly relaxed to encourage economic growth, taking into account factors such as GDP expansion and inflation rates.
The data collected through CBDCs has the potential to be paired with strict reserve requirements for commercial banks, creating a theoretical framework for inflation control. However, it is important to note that such a framework has never been put into practice. CBDCs are still a relatively new concept globally, and central banks are in the process of exploring their optimal utility. Argentina's presidential candidate, Sergio Massa, envisions CBDCs as a tool to combat inflation if elected. The true utility of CBDCs is still unfolding, and only time will reveal their full impact on the global financial landscape.
Sauradeep Bag is an Associate Fellow at Observer Research Foundation
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Sauradeep Bag is Associate Fellow at ORF. Sauradeep has worked in several roles in the startup ecosystem and in international development with the United Nations Capital ...Read More +