RIO DE JANEIRO, BRAZIL – It is not a question of if, but when. The intense work of a large number of central banks around the world makes it almost a certainty that in the coming years, several of them will issue a digital version of their currency.
In addition to a significant challenge for private, non-governmental, cryptocurrencies, such as bitcoin, this will also have consequences for emerging markets, particularly those with high macroeconomic instability and inflation and a weak currency, such as Argentina.
The effect will include positive aspects, such as a decrease in remittance costs for emigrants residing in major countries, who send money to their countries of origin, but also negative macroeconomic impacts because if the design of digital currencies allows their holding by foreigners, it will increase currency substitution and financial instability and reduce “seigniorage” (the benefit obtained from freely issuing one’s money) in emerging countries.
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The warning, with emphasis on the situation in Argentina, which he mentions several times as a prominent case, was issued by the Chilean-American economist Sebastian Edwards, professor at the University of California at Los Angeles (UCLA) and former chief economist of the World Bank for Latin America, in a recent study published by the National Bureau of Economic Research (NBER), the most prestigious economic research institution in the United States.
Edwards, who last year, in an interview with Infobae, had pointed out that “Argentina’s economy continues to apply measures that have not worked since the mid-20th century”, cites a report by the Bank for International Settlement (BIZ) in Basel (a sort of “central bank of central banks”) the number of entities actively working on the digital issuance of their currency has doubled in the last three years. In most cases, they aim at “general purpose” digital currencies, including their use in retail transactions.
This media also referred to another detailed study on the tests and examinations of various advanced and developing countries for the eventual issuance of digital currencies.
BEFORE 2025
One conclusion of the study is exact in this regard: “Central banks collectively representing one-fifth of the world’s population are likely to issue their general-purpose digital currency in the next three years (before 2025)”, although it considers it unlikely that most of the world’s central banks will do so “in the foreseeable future”.
The objectives of issuing the digital dollar, euro, and yuan, three of the ongoing projects, are to improve the efficiency and reduce the cost of the payment system, encourage financial inclusion, and facilitate and reduce the costs of cross-border transactions.
The European Central Bank also stressed that the issuance of the digital euro would provide a new and more efficient channel for monetary policy transmission and lower the costs and “ecological footprint” of the financial and payments system.
Much of the impact will depend on the specific architecture that central bank digital currencies (referred to as CBDCs or “govcoins”) will adopt; how widely they are used, whether they will pass through the banking system or directly through the issuing central bank, and how well and effectively the privacy of users will be protected.
DEFINITIONS ON FUNDING
These issues involve definitions about the funding of digital currencies, the use of decentralized technologies, such as blockchain, or the issuer’s architecture (which will define the traceability of the money, key in the fight against money laundering and other illicit activities).
They will be accessed based on identity or tokens (similar to the current difference between using a digital means of payment, such as cards and QR, or cash), which raises fears about excessive state power and control and the possibility of limiting individual ownership, which in turn is related to the dilemma of whether e-currencies will be used only for trading or also for savings.
In this regard, Fabio Panetta, member of the board of the European Central Bank, said that for the euro-digital to work well, its use as a savings and investment channel must be limited, discouraging or prohibiting holdings (at every moment: the so-called “demand for money”) exceeding 3,000 digital euros per person.
For emerging market economies and currencies, especially in unstable and highly dollarized countries such as Argentina, the most basic definition is whether, for example, the “digital dollar” eventually issued by the US Fed will allow foreigners to hold it because in that case, it would deepen “currency substitution” and – Edwards wrote – probably increase financial instability in some emerging markets while reducing seigniorage”.
THE CASE OF EL SALVADOR
The economist stresses that in the case of the recent decision of the government of El Salvador to confer legal and forced status to bitcoin, the “currency substitution” effect (at the expense of the local one) is not essential.
Firstly, because bitcoin is a private cryptocurrency and its high volatility doubts its status as “money”. And also, because this Latin American country does not have its currency: Salvadorans already used the dollar and were not looking for a stable currency to serve as a store of value, medium of exchange, or unit of account.
Argentina would be different; he explains, “where the dollar circulates on a par with the local currency”.
For emerging markets, says Sebastian Edwards, the three central issues are the effect that a digital currency such as the dollar or the euro would have on their ability to have their monetary policy and control the functioning of financial markets, the regulatory implications, particularly on “prudential rules”, and what would happen if the digital issuer allows its e-currency to be used in cross-border transactions.
In such cases, an e-dollar would more strongly affect the local price level, the exchange rate, and the seigniorage of emerging central banks.
The challenge, he insists, is more acute for countries with a history of high inflation, where people flee from holding local money. In this regard, Edwards cites Milton Friedman, the father of monetarism, who remarked that a stable demand for money is fundamental for the effectiveness of the monetary policy.
The study also cites a recent IMF report that says: “the adoption of digital money implies risks and policy challenges”: by increasing currency substitution, increasing vulnerability, and currency mismatch, it ultimately affects the Central Bank’s capacity.
“Without appropriate safeguards,” Edwards adds, “this can facilitate illicit flows and make it more difficult for regulatory authorities to enforce exchange and capital controls” and affect capital flows. A weak Central Bank would become almost entirely impotent.
Much of Sebastian Edwards’ study then focuses on the issue of “currency substitution”, quoting extensively from a paper by Argentina’s Eduardo Levy Yeyati, published last March, which distinguishes between “financial dollarization” (basically savings) and “real dollarization” (transactions, especially in high-value operations). Once a country or region starts using cash dollars, cites another study, dollarization increases with each new crisis.
ARGENTINA AND PERU
According to Edwards, Latin America presents two notable cases; Argentina and Peru. In Argentina, dollar circulation represented 22% of GDP in 2006; in 2019, even a book entitled “The dollar, history of an Argentine currency” was published, and in the last two years, says Edwards, the country continued with its high level of instability: inflation above 50% per year and the use of US$100 bills “in all types of transactions”.
In contrast, he notes, Peru has had a stable macro-economy, low inflation, and a firm exchange rate for the past 20 years, even though legally, there is complete substitution and ATMs dispense both dollars and nuevos soles, the country’s currency.
There, it says, “there does not seem to be a risk of a flight from the local currency, even if (the issuance of the digital dollar) greatly reduces transaction costs”. Levy Yeyati’s working paper states that in the last 15 years, despite its political volatility, Peru has undergone a process of “de-dollarization”.
MODEL AND ESTIMATES
In an academic vein, Sebastián Edwards then builds a model, compares situations and estimates, based on certain assumptions, that with the digital dollar, the demand for local currency in Argentina would be 30 times more sensitive than in Peru to changes in inflation expectations, which would multiply the quantum of the consequent devaluations and make monetary policy ungovernable.
In these circumstances, he adds, such exchange rate jumps would increase the vulnerability of the local financial system, requiring greater regulatory oversight and stricter “prudential regulations”.
Such jumps, he stresses, would have real effects, as they would limit the ability of firms to borrow in foreign currency or to pay debts through the banking system or other financial intermediaries. This, in fact, “looks like one of the most formidable policy challenges ahead for emerging nations.”
As for the negative effect on the “seigniorage” of central banks, Argentina is again a remarkable case, insofar as it reached 50% of fiscal revenues, compared to 26% in Peru, 22% in Bolivia and Brazil, and 13% in Colombia and Ecuador, against only 2% in the emerging countries of Eastern Europe.
Edwards compares the cases of Argentina, Chile, and Mexico. “Not surprisingly,” he says, the “tax base” of seigniorage is lower in Argentina because of its tradition of instability and high inflation, which causes people to flee the peso.
This results in 28% of GDP (in 2017), against 45% in Mexico and 85% in Chile. As the base is lower, the “inflationary tax” should be higher, as it is. If Mexico had the same “base” as Argentina, Edwards calculates, it would lose up to 38% of its seigniorage, no less than 1% of GDP.
TWENTY YEARS IS NOTHING
In this regard, Edwards recalls that in 2000, the then-Republican Senator for Florida, Connie Mack, presented a bill. If Argentina dollarized, the Federal Reserve would pay the “seigniorage” it would lose, giving up its currency.
The bill was never discussed, but the fact that it was discussed at that level, Edwards concludes, clarifies that international cooperation will be essential to avoid the effects of the eventual issuance of the dollar or another digital currency with a potential impact on emerging markets.
As for the beneficial effect, the study points out that the average cost of sending remittances from emigrants to their countries of origin is 8% of the value sent but reaches up to 18% / 19% in some Asian countries.
Among the countries that would benefit most from the cost reduction implied by the issuance of digital currencies are Haiti, Lebanon, and South Sudan, where remittances represent between 30 and 40% of the respective GDP.
In Central American countries such as Honduras and El Salvador, the proportion exceeds 20%, and in Nicaragua and Guatemala, it is close to 15%.
Argentina is far from the situation of these countries, whose “digital benefit” would be proportional to the number of expatriates. But it should be concerned about being among the main losers of the eventual and almost inevitable issuance of digital currencies due to its status as a seismic economy.
With information from Infobae