The monetary, fiscal challenges of cryptocurrency

News: Digital money in the form of cryptocurrencies is gaining widespread popularity, esp with countries like El Salvador adopting Bitcoin as a legal tender. The debate around Cryptocurrencies frequently refer to their speculative nature as a cause of concern.

But, what happens if, over time, cryptos evolve from speculative assets to become viable mediums of exchange? What would this imply for the conduct of monetary, fiscal and exchange rate policies?

Are cryptocurrencies viable as a medium of exchange?

Anything in excess supply is cheap. So whenever a central bank prints more and more currency, its value erodes over time.

The global financial crisis of 2008 resulted in a similar unprecedented expansion of G3 central bank balance sheets. This sparked fears of debasement (lowering of value) of currency.

To prevent a similar thing from happening to Bitcoin, the founders fixed its supply to a set number. One unintended side effect of this was that, like a usual currency, the supply of Bitcoin could not be modified as per demand. This often causes price volatility, i.e. huge upward or downward movement of price.

This in turn means that Bitcoin or any other Cryptocurrency is not suitable as a medium of exchange.

Instead, it is a speculative asset.

How do stable coins solve the problem of price volatility?

To get around this issue, Stablecoins, like USDT (Tether), have been introduced, whose value is pegged to a fiat currency by maintaining equivalent reserves (think of a “currency board” exchange rate regime).

By providing much greater price stability, these Stablecoins hope to serve as viable mediums of exchange, and have proliferated rapidly in recent years.

Still, the risk to the monetary policy will depend on the degree of currency substitution.

What are the implications of widespread adoption of Cryptos as mediums of exchange?

Impact on monetary policy: If a privately-issued cryptocurrency begins to compete with fiat currency, something similar to Dollarisation, i.e. e-Dollarisation, would happen. For instance: In various Latin American countries, as citizens lost faith in domestic currency, they began transacting more and more in Dollars. This rendered domestic monetary policy ineffective, because domestic central banks cannot set interest rates and inject liquidity in a foreign currency.

Widespread adoption of privately issued digital currencies as a medium of exchange will have the same impact. The domestic monetary policy will not be able to respond to business cycle needs and external shocks.

Independent creation of money: If the privately issued Global Stablecoins gain credibility and acceptance over time, they can delink from reserve currencies such as dollar and become independent creators of money. This will dent the domestic monetary policy of emerging and developing countries?

Advantage to US: Moreover, the US might actually see that as an advantage as it will strengthen the reach of the dollar, and therefore be disinclined to regulate them.

Mega tech companies may start running global e-commerce or social networking platforms, issuing their own digital currencies to their global customer base. These digital currencies will serve both as a unit of account and a medium of exchange on their platforms.

Reorganisation of global economic activity into digital currency areas (DCAs) that run across national boundaries. These DCAs will be characterised by their own digital currency and unit of account issued by the network owner. The size of these DCAs might become larger than various national economies.

Loss of seigniorage revenues: When the RBI buys assets such as government securities, it pays for them by printing currency – in effect creating money out of thin air. The returns RBI earns on the assets so bought constitute its seigniorage revenues which eventually accrue to the government. Cryptos would impact this revenue by rendering money supply itself a less potent policy instrument.

Fiscal revenues can also be adversely impacted by the increased tax evasion opportunities that crypto-currencies can facilitate.

In the light of an ineffective monetary policy, the burden on fiscal policy to respond to economic shocks will commensurately rise. This could create challenges in a post-Covid world.

Impact on rupee:

– Capital outflows: Cryptos would become conduits for capital outflows as investors put domestic money in the crypto exchange and exit out of it abroad in a hard currency. China is reported to have lost as much as $80 billion via cryptos last year before it banned all crypto transactions this September. Managing the capital account consistent with their inflation targets is already a complex challenge for emerging economy central banks like RBI. Capital flight via cryptos will worsen that challenge.

What is the way forward?

The implications of widespread crypto adoption are complex and interlinked. But, the true challenge will be if the unbacked private digital currencies are seen as viable mediums of exchange. That’s what policy must anticipate and prepare for.

Source: This post is based on the article “The monetary, fiscal challenges of cryptocurrency” published in The Indian Express on 19th Nov 2021.