Fostering negative interest rate policy through digital currency (CBDC)

The collapse of Lehman Brothers in 2008 triggered the global financial crisis. To combat, central banks cut the interest rates to near zero. A decade later, interest rates still remain low in most countries.

With no room to further cut rates, some central banks have implemented unconventional policy measures, a negative interest rate policy. For example, The European Central Bank (ECB) on Jun 11, 2014, set the interest rate from 0.0 to -0.10 percent. It further reduced to -0.50 percent on Sept 18, 2019.

Other countries that have set the negative interest rate on excess reserves are in countries Switzerland, Denmark, Sweden, and Japan.

Reasons for adopting negative rate policy:

Under a negative rate policy, financial institutions are to pay interest for parking excess reserves with the central bank. With such a policy, banks get penalized and therefore, lend more money freely to businesses and consumers.

The negative interest rate weakens a country’s currency by making it a less attractive investment giving the country’s export a competitive advantage and boosts inflation by pushing up import costs. This is also one of Trump’s motivations for wanting negative rates on the dollar.

For instance, Japan adopted the negative interest rate in 2016 to prevent yen strengthening from hurting an export-reliant economy. It charges 0.1% interest on a portion of excess reserves financial institutions park with the central bank.

Limitations of pushing negative rates to retail depositors:

There are also limits to how deep central banks can push negative rates. Far extending the negative rates may lead banks to pass rates to depositors. This may change depositors’ behavior to the extent that they rather choose to store actual banknotes, diminishing the effectiveness of the negative rate policy measure.

Replacing cash with digital currency is one-way to resolve the above-said circumstance. Taking advantage of recent technology development, such as distributed ledger technology or AI, central banks are now evaluating the issuance of digital currency.

A blockchain-based transaction system with smart contracts compatibility can help to effectively apply the monitory policy, especially negative rates.

A careful consideration to issue a central bank digital currency (CBDC):

Irrespective of the technology central bank pick to develop the digital currency, central banks also have to make a hard choice – replacing banks. Using CBDC could help authorities to gather users spending information to combat money laundering, tax evasion, or financing criminal activities. On the other hand, it can put the banking system at risk or may even replace commercial banks.

Experts suggest central banks are not going to wipe-out cash from the market on day one of CBDC launch. They will follow the phased approach.

During the initial phase, central banks with the agenda of negative rate policy may introduce a dual currency scheme. Meaning dividing the monetary base into two local currencies – cash and CBDC. Under this arrangement, cash would have an exchange rate. A conversion rate lower than CBDC (not 1-to-1) and thereby, manipulate to match negative rates.

China is close to launching its CBDC called ‘digital currency electronic payment’. It uses a two-tier system in which institutions distribute the digital currency. Also, it would have no implications for inflation or monitory policy. The world’s financial leaders are carefully observing China’s CBDC development, especially the after-effects of the issuance.

To Sum-Up:

Setting negative rates may work to boost economic growth through financial means. A desperate, critical measure to encourage more lending or spending to revive the economy. However, it is certain to cause unrest in the general public, particularly after experiencing decades of positive nominal rates.