Exploring the Impact of CBDCs on Monetary Policy in Conventional and Islamic Banking Systems

Are you interested in learning about the potential implications of Central Bank Digital Currencies (CBDCs) on monetary policy in jurisdictions with conventional and Islamic banking systems? If so, you're in the right place! In this blog post, we will explore a working paper published by IMF titled "Monetary Policy Implications of Central Bank Digital Currencies Perspectives on Jurisdictions with Conventional and Islamic Banking Systems" by Inutu Lukonga. Central banks worldwide are actively exploring the issuance of CBDCs to preserve access to public money in an increasingly digital economy. However, poorly designed CBDCs can have adverse macroeconomic consequences, including monetary policy. This paper provides a conceptual analysis of the monetary policy implications of issuing CBDCs and identifies potential strategies to minimize unintended consequences of CBDCs on monetary policy in jurisdictions with conventional and Islamic banking systems. Let's dive in!

What is Central Bank Digital Currency (CBDC)?

Alright, so let's start by breaking down what CBDC means. CBDC stands for "Central Bank Digital Currency", which is a type of digital money that is issued and backed by a country's central bank. This means that CBDC is a payment instrument that is directly linked to the central bank of a country and is denominated in the national unit of account.

There are two main types of CBDCs: retail and wholesale. Retail CBDCs are designed for use by the general public in day-to-day payments and transactions, while wholesale CBDCs are designed for use among financial institutions.

Now, when it comes to designing CBDCs, there are a lot of different options that central banks can choose from. These different design options have different characteristics that can impact monetary policy. Some design options can pose risks to monetary policy, while others can moderate potential risks.

For example, retail CBDCs have characteristics that pose greater risks for monetary policy than wholesale CBDCs. One of these risks is deposit disintermediation, which means people could withdraw their money from banks and hold it in the CBDC instead. This could reduce credit availability or raise credit costs for businesses and governments.

To make matters worse, if the CBDC is remunerated, which means it earns interest, it becomes an even more attractive option for people looking to store their money, potentially making the problem even worse. Additionally, one can store digital money in an unremunerated CBDC that does not attract fees. And just like how some banks charge fees for maintaining accounts, some demand deposits may charge account management fees. But a retail CBDC that doesn't attract fees can be more appealing than a demand deposit that does charge fees.

The way the CBDC is distributed also has an impact on the economy. If it's a single-tier distribution model, where the CBDC is directly distributed to the public, it can disrupt the payment system structure and pose a greater risk to monetary policy.

However, the design of the CBDC can also help mitigate these risks. For example, if the CBDC has caps or transaction limits, or if it requires full disclosure of transactions, this can help reduce the risk of deposit disintermediation and other negative impacts on the economy.

Finally, it's worth noting that many central banks around the world are currently researching or conducting pilot experiments on CBDCs. While many countries are still in the preliminary stages of CBDC research, there is a growing trend to align CBDC designs with foundational principles to safeguard price and financial stability.

How CBDC Impacts Monetary Policy: Exploring the Relationship Between CBDC and Managing the Money Supply

Monetary policy is all about managing the money supply in an economy to achieve things like stable prices and steady economic growth. A CBDC is a new way of making payments, and it can have a big impact on how monetary policy is carried out.

When a country issues a CBDC, the goals of monetary policy don't change, but the way it's carried out can be affected. Central banks use a set of rules and strategies to make sure monetary policy is effective, and these can include things like setting interest rates or targeting inflation levels. They also need to communicate clearly with the public about what they're doing and why.

There are different ways of carrying out monetary policy, depending on the country and the economic situation. For example, some central banks might target exchange rates or inflation, while others focus on the money supply. They also use different tools to achieve their goals, such as adjusting interest rates or buying and selling government bonds.

The effects of monetary policy can be felt in different ways, such as through changes in interest rates or the availability of credit. Financial institutions play a big role in transmitting these effects throughout the economy, so they need to be efficient and effective.

Overall, the introduction of a CBDC can have important implications for how monetary policy is carried out, and it's important for central banks to carefully consider the effects on the economy and financial system.

CBDCs: How They Impact Payments, Monetary Policy, and Cross-Border Transactions

When the central bank issues CBDCs, they can have a big impact on how people and businesses make payments, which in turn can affect how monetary policy is implemented and transmitted throughout the economy.

When retail CBDCs are introduced, people may exchange some of their cash and deposits into CBDCs, which can lead to changes in the public’s holdings of cash and deposits. This can erode the effectiveness of money-targeting regimes, weaken the lending and interest rate channels, and impair central banks’ capacity to forecast commercial bank reserves.

On the other hand, wholesale CBDCs are like reserves that don't affect monetary policy, but they do make payments more efficient and change how the market works. They can be transferred between financial intermediaries using Distributed Ledger Technology (DLT), which allows for secure and transparent transactions. One benefit of W-CBDCs is that they can be embedded with smart contracts, which allows for more autonomy and less human intervention in operations.

Another important aspect of CBDCs is their potential for use in cross-border transactions. With CBDCs, non-residents can use central bank money in cross-border transactions without having to go through intermediaries, which can make transactions faster, cheaper and more convenient. However, there are also some risks involved, such as negatively affecting the issuing country's ability to control its monetary policy or reducing the monetary authorities' control over domestic liquidity.

Understanding the Impact of CBDCs on Monetary Policy: Risks and Opportunities

So, while we don't know for sure how CBDCs will affect monetary policy, we can look at past technological changes in finance to make some educated guesses. While past changes haven't completely disrupted central banks' ability to control monetary policy, sudden changes in capital flows and other factors have presented challenges. In particular, sudden reversals of capital flows, deposit runs, liquidity gridlocks, dollarization, and volatility in commercial bank reserves have posed challenges to financial stability, exchange rates, and monetary policy. As a result, policymakers will need to carefully consider the potential risks and challenges posed by CBDCs to ensure that they can effectively implement and transmit monetary policy.

Retail CBDCs, Deposit Disintermediation and Changes to Money Velocity

Deposit disintermediation is another important term to understand. This means that people might stop depositing their money in banks because they can use CBDCs instead. This could cause problems for the banking system and how it operates. It could also make it harder for the government to manage the economy by adjusting interest rates, for example.

Changes in money velocity refer to how quickly money moves through the economy. If people start using CBDCs instead of depositing their money in banks, it could change how quickly money moves around. This could have consequences for inflation and other economic factors.

When cash is still used a lot for transactions, the introduction of digital payment methods can cause a significant decline in the use of cash, which can be good for monetary policy. However, factors such as low-interest rates and economic uncertainty can cause people to hold on to cash more, which can offset the effects of digital payment innovations.

Despite the decline of cash usage in many countries, there are still many countries where cash is used a lot. For these countries, there is a lot of potential for the adoption of digital payment methods, such as CBDCs. The low penetration of private digital payment instruments, such as credit and debit cards, and the low share of ATMs in emerging markets and developing economies (EMDEs) suggest a substantial scope for countries to adopt CBDCs. A CBDC that is available to the unbanked and charges no fees or lower fees could appeal to a broader segment of the population.

However, changes in money velocity can also erode the effectiveness of the monetary policy, and cause inflation. Financial innovations that cause changes in money velocity have contributed to the decision by some countries to change their monetary policy targets. Overall, the impact of changes in money velocity on monetary policy is complex and depends on several factors such as interest rates, economic uncertainty, and payment innovations.

The risks associated with CBDCs depend on how quickly they are adopted and how widespread they become. If people start using them too quickly, it could cause problems for the banking system and the economy as a whole. However, if they are introduced slowly and carefully, they could help improve financial inclusion and make transactions more efficient.

W-CBDCs, Tokenization and Financial Market Segmentation

There are some uncertainties surrounding the impact of this new currency on monetary policy implementation and transmission. While there is a lot of optimism about DLT, it is still in the early stages of development, and it could take years before it is fully implemented in the real world.

If DLT is widely adopted, it could enable the tokenization of financial markets, which could have both positive and negative effects. On the one hand, it could enhance efficiency in security settlement, but on the other hand, it could increase the risk of market segmentation.

The potential risks of market segmentation arising from the tokenization of financial assets and associated liquidity challenges will need to be better understood. Some pilots have shown that introducing w-CBDC could lead to some segmentation of the money market, which could negatively affect the efficiency and liquidity of the money market. The risk of market fragmentation and inefficiencies would increase if w-CBDC is designed to be used in a separate payment rail and is not interoperable with the current system.

Furthermore, using a new currency like w-CBDC could require financial institutions to operate and maintain balances in two separate systems, which could alter market structures and require a significant amount of liquidity for settlement while potentially fragmenting the supply of liquidity.

On the positive side, using DLT to shorten the time between trade and settlement, especially for DvP or instant settlement, can reduce the replacement cost risk but could increase liquidity requirements associated with the need to prefund positions.

Finally, there is also the question of the interest rate setting mechanism if settlement moves to 24/7, which means transactions could happen around the clock. 

Cross-Border Use of CBDCs, Currency Substitution and Capital Flow Volatility

If CBDCs become widely used across borders, it could affect the monetary policy of both the countries that issue the CBDCs and the countries that receive them. The risks for countries that receive CBDCs are higher, especially during times of crisis. However, the risks for countries that issue CBDCs are more manageable.

For issuing countries, the risks to the monetary policy of issuing CBDCs with cross-border functionality appear to be manageable. The availability of CBDCs across borders does not in itself guarantee demand for the CBDC. The value of a country’s central bank money is linked to the credibility of the central bank that issues it and the strength of its macroeconomic performance. The impact on monetary aggregates of increased demand for a country’s currency could be inconsequential.

For recipient countries, the risks to monetary policy from currency substitution, sudden capital flow reversals, and reduced seigniorage (profits from printing money) could be significant, particularly in crisis periods. CBDCs could enable easier and more convenient access to reserve asset currencies, and this could encourage people to hold foreign CBDCs, especially in countries with weak economies. If CBDCs lead to faster cross-border transactions, the increased speed could enable capital flow volatility, which would present challenges for exchange rates and monetary policy.

However, the risks of these things happening in the near term are low because cross-border use of CBDCs would require countries to issue CBDCs first and ensure that their platforms are interoperable.

There are also concerns over the geopolitical implications of foreign CBDCs circulating at home and foreign countries obtaining information on citizens. There are also national security concerns that could arise from sharing critical infrastructure with other central banks.

If geopolitical concerns are overcome, there are still many technical and legal challenges that will need to be resolved before the use of CBDCs in cross-border transactions becomes a reality. The pilots on cross-border CBDC schemes have, thus far, involved a few countries, and questions remain about the scalability of platforms.

Overview of Islamic Financial Systems and Monetary Policy Frameworks: Considerations for CBDC Design and Shari'ah Principles

In jurisdictions with Islamic banks, the way monetary policy works are pretty similar to conventional banking systems. They also have a nominal anchor, operational targets, and intermediate targets.

The only difference is that in Islamic banking systems, there's an added objective of promoting equitable distribution. This means that they aim to make sure that everyone benefits from the economy's growth, not just a small group of people.

Now, when it comes to the nominal anchor, which is basically the thing that central banks use to measure the value of money, most jurisdictions with large Islamic finance sectors have adopted exchange rate targeting regimes. This means that they focus on keeping the exchange rate stable, which has been successful in keeping inflation low.

However, this can restrict the independence of monetary policy, which means that macroeconomic management mostly relies on fiscal policy. And because Islamic banks can't use conventional mechanisms of liquidity management that is based on interest, central banks have to either modify traditional instruments or develop new Shariah-compliant monetary policy instruments and interbank and capital markets.

Unfortunately, the market for Shariah-compliant money market instruments is mostly underdeveloped, which means that Islamic banks tend to hold more cash than necessary. And in some cases, Islamic banks don't participate in conventional monetary operations and interbank markets, creating a segmentation between Islamic and conventional money markets.

Shari'ah Principles and CBDC Designs

Now, if a central bank wants to issue a CBDC in an Islamic setting, they have to figure out how to do it without involving interest payments and therefore remunerated CBDC is not an option. One way to do this is to design a CBDC that incorporates a profit-sharing mechanism, where the profits earned from holding the CBDC are shared among the holders.

Another issue to consider is how tokenized financial markets would operate in an Islamic banking setting. The Sharia’h principles prohibit speculation, which means that CBDCs cannot be used for foreign exchange derivatives transactions. In other words, you cannot use CBDCs to make bets on the future value of a currency.

So, the bottom line is that when designing a CBDC in an Islamic setting, central banks have to consider these Shari’ah principles and come up with solutions that comply with them.

How CBDCs Might Affect Monetary Policy in Countries with Islamic Banking Systems

Now, let's talk about how CBDCs might affect the way monetary policy works in countries with Islamic banking systems. First of all, it's important to know that Islamic banking systems don't allow for interest payments on deposits. Instead, banks rely heavily on unremunerated deposits, which basically means that people put their money in the bank without expecting any interest in return.

Now, CBDCs can be a problem because they're essentially a perfect substitute for these unremunerated deposits. This means that people might start moving their money out of the bank and into CBDCs, which could lead to what's called bank disintermediation.

The risk of bank disintermediation is especially high in countries where retail deposits make up a large portion of bank funding, such as in the Gulf Cooperation Council (GCC) countries. These countries have a lot of small retail deposits, which are generally considered to be stable sources of funding, but they also make it hard to limit how much people can put into CBDC digital wallets.

Another problem is that the Islamic finance markets aren't very developed, which could make it hard for the central bank to manage liquidity risk. Islamic banks can't access interest-bearing liquidity facilities like conventional banks can, and there aren't many sharia-compliant money market instruments for liquidity management. This could limit the central bank's ability to act as a lender of last resort (LOLR), which is something they can do in emergencies to provide liquidity to banks.

Finally, while there are some Islamic liquidity management instruments (ILMI) available, they're not standardized and there aren't many Islamic banks in most countries. This could make it harder for banks to manage their liquidity and could constrain the effectiveness of a LOLR.

So, to sum it up, CBDCs could have some unintended consequences for how monetary policy works in countries with Islamic banking systems, especially if people start moving their money out of banks and into CBDCs. The underdeveloped Islamic finance markets could also make it harder for the central bank to manage liquidity risk and act as a LOLR in emergencies.

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

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