How the digital currency revolution can boost financial inclusion and investment

Central banks worldwide are embracing digital technology as they edge closer to launching their own digital currencies. How will this affect monetary policy in the future, particularly in emerging markets where many people lack access to bank accounts? We believe that as central bank digital currencies (CBDCs) are adopted in these countries, more people will become directly exposed to interest rate decisions and monetary policy’s power will strengthen. This could help emerging markets’ monetary policy move towards levels of efficacy seen in developed markets. Monetary policy affects most people in emerging markets only through indirect channels – such as inflation and the exchange rate – because many people lack access to a bank account. Moreover, many developing economies prefer to keep currency fluctuations within a band pegged to the currencies of their major trading partners to maintain competitiveness. This leaves output and inflation as the main avenues through which most citizens are affected by monetary policy. Although the effect on output from monetary policy changes helps employment, the consequences of inflation are felt most by those outside the financial system, particularly those who cannot easily protect the value of their savings. By contrast, policy rates in developed markets influence much of the population through interest rates on savings accounts, financial instruments and loans. This difference is the key reason monetary policy in developed markets is more effective at stabilising the business cycle and inflation. Our estimates show the effect of monetary policy on output is two‑thirds more powerful in a country with high financial inclusion relative to one with low financial inclusion. Emerging-market CBDCs now in circulation, such as the Bahamian sand dollar, let people access banking services with the ease of opening CBDC accounts. Interest rates on these accounts could have greater influence on account holders’ spending decisions. Therefore, central banks will be able to better mitigate shocks and reduce economic volatility. The use of digital currencies will also help people and businesses build a verifiable history of income and spending, which can support loan applications. Greater access to credit will shift reliance from shadow banks to regulated financial intermediaries, which are likely to offer interest rate products linked to the central bank policy rate. In low- and middle-income countries, this technology could increase the proportion of the population in the financial system. That would make monetary policy in these countries more effective. Greater access to bank accounts will increase the level of individual savings available for investment in the economy, which would make developing countries running current account deficits less dependent on foreign capital. Although the initial impact is likely to be negligible, the effect will grow over time as more people gain access to banking services and build savings. In the long term, we believe monetary policy will become more dependent on local economic conditions than external conditions, which will help central banks achieve their targets and improve financial stability. Booming digital economy must still make space for cash payments Issuing CBDCs will also have implications for the structure and size of the emerging-market central banks’ balance sheets. CBDCs will be a liability on the balance sheet, so there must be an asset on the counterpart. In developed countries, the natural asset is government debt, given its low-risk properties. In many developing countries, government debt is considered riskier and might have a low credit rating, in which case people might not be willing to hold CBDCs backed by local government debt. A possible solution would be for emerging-market central banks to issue CBDCs against developed-market government debt, reducing the riskiness of CBDCs and encouraging their use. As monetary policy becomes a more powerful tool in managing the economy in emerging markets, the equilibrium interest rate is likely to fall. Furthermore, the lower volatility of output and inflation will lead to a fall in the volatility of interest rates, reducing premiums and lowering the level of long‑term bond yields. The net impact will vary by country and depend on the current level of financial inclusion, the effectiveness of monetary policy and the speed at which CBDCs are implemented. We believe the difference in impact will also create relative value opportunities for investors. Tomasz Wieladek and Aadish Kumar are both international economists at T. Rowe Price