Central bank digital currencies a useful tool for emerging markets, but are not without risks

Countries with the least credible fiscal or monetary policies in the EM universe face the threat of 'digital dollarisation', BofA Securities says

A street vendor selling products in El Salvador. The country passed a law on Wednesday allowing Bitcoin to be used as legal tender. Other emerging market nations are developing their own central bank Show more

Emerging market countries have been frontrunners in the adoption of digital currency projects, which could boost financial inclusion, according to a new report.

However, countries adopting digital currencies face risks, such as increasing digital dollarisation as they gain access to other countries and a potential rise in local inflation rates, according to BofA Securities.

"Central banks representing a fifth of the world's population are likely to issue a general purpose CBDC in the next three years, according to the latest Bank of International Settlements survey. Eighty-six per cent of global central banks are exploring the benefits and drawbacks of CBDCs. About 60 per cent are conducting experiments or proof-of-concept,” the bank said in a research note.

“The most advanced central bank digital currency projects are currently run in China, [South] Korea, Singapore, South Africa, Thailand and the UAE.”

CBDCs are digital forms of national currencies such as the dollar, the euro or the dirham, backed by a country's central bank.

A growing number of nations are trialling CBDCs and central bankers and finance ministers from the Group of Seven nations last week pledged to work together to understand "their wider public policy implications".

"Our objective is to ensure that CBDCs are grounded in long-standing public sector commitments to transparency, the rule of law and sound economic governance," the policymakers said in a joint communique.

The UAE has already completed Project Aber, a CBDC proof-of-concept trial with Saudi Arabia last year, which confirmed blockchain technology could be used to “reimagine both domestic and cross-border payment systems in new ways".

In February, the UAE Central Bank also joined a multi-nation project with the Bank of Thailand, the Hong Kong Monetary Authority and the Digital Currency Institute of the People’s Bank of China to examine the business use cases for using blockchain for real-time, cross-border payments in both domestic and foreign currencies.

Central banks in emerging markets are adopting CBDCs because they can bring significant efficiency gains in payment systems. They can also help to boost financial inclusion, given that more than 50 per cent of people in developing countries do not have a bank account.

Bitcoin trading is higher in emerging market countries where fewer people have bank accounts, according to BofA’s report, with nine of the top 10 countries in terms of cryptocurrency adoption being emerging markets, according to Chainalysis.

Digital currencies could also lower the cost of remittances, which is a major source of income for many emerging markets.

Remittances account for 10 per cent of gross domestic product of the Philippines and Ukraine.

A BIS survey based on a sample of 112 countries found that the average cost of a $200 bank-based cross-border transfer was more than 10 per cent of the transaction value.

“This cost for emerging markets amounts to about $50bn annually. If it can be saved, it would be a considerable gain for the populations of many emerging markets,” the report said.

However, a more widespread adoption of CBDCs by emerging markets also carries risks, especially in countries where fiscal or monetary policy is considered to be lacking in credibility and where citizens attempt to hold savings in hard currencies such as the US dollar.

In countries where dollarisation rates are currently low, the adoption of CBDCs will not make much difference. But in countries where it is high, easier access will increase the process – a phenomenon known as “digital dollarisation”.

It also risks disintermediation for emerging market banks, which could lead to greater volatility in their banking systems.

The potential for central banks to more easily use digital currencies as stimulus also carries the risk of higher inflation and increased asset prices, the research note said.

Yet, CBDCs also offer emerging market countries an alternative to “unregulated cryptocurrencies offering an alternative medium of exchange or store of value for high-net-worth individuals seeking to avoid their gaze”, said Hasnain Malik, managing director of emerging and frontier market strategy at Tellimer Research.

“That would be even worse than traditional ‘dollarisation’ because capital would potentially permanently escape their supervision.”

Cryptocurrency adoption has been greatest in countries where confidence is lowest in the local currency or legal environment, he said.

“It is no coincidence that, at one extreme, El Salvador is going to accept Bitcoin as legal tender. It had no currency of its own in the first place.”