Currency Substitution in a World of Looming Retail CBDCs : Suggestive Currency Substitution-Based Evidence

This paper is written by Hongyi Chen (Hong Kong Institute for Monetary and Financial Research) and Pierre Siklos (Wilfrid Laurier University and Balsillie school of International Affairs).Digitalization, spurred by the pandemic, has accelerated plans by many central banks to introduce retail digital currencies (rCBDCs). If international coordination eventually allows individuals to hold digital multiple currencies, this potentially implies greater scope for currency substitution. The potential to ease constraints on currency substitution dovetails nicely with the G20’s continuing aspiration to enhance digitalization as a “tool” to improve economic performance and reduce inequality. Nevertheless, as discussed in our study, opportunities for individuals and small businesses to exploit the promise of lower transactions costs thanks to digitalization will be difficult to realize in the current regulatory and geopolitical environment. Nevertheless, policy makers will not be able to make appropriate choices unless they appreciate the scope for currency substitution in a world with rCBDCs. Accordingly, this paper provides new estimates of the potential for currency substitution using data from a cross-section of advanced and emerging economies. In contrast to the existing literature, we apply existing econometric methodologies in novel ways to generate estimates of the degree of currency substitution conditional on technological and institutional factors. These are critical ingredients in the potential success of rCBDCs on a global scale.Our empirical study asks: What is the scope for currency substitution? It uses data from a cross section of advanced and emerging economies, large and small, and with varying degrees of openness. First, we estimate for a panel using Generalized Method of Moments whether the degree of currency substitution differs between advanced economies (AE) and emerging market economies (EME). For narrow definitions of money, the answer is negative. For a broader definition of the money supply the differences are statistically significant. Indeed, the scope for currency substitution is larger for the group of emerging market economies considered.Next, we consider what happens when we think of the digitalization of money as a treatment or intervention. We estimate difference-in-difference models to estimate the possible impact on money demand using narrow and broad definitions of money. Generally, the results support those obtained using the Generalized Method of Moments method although the size of the currency substitution effect is smaller.Important policy implications stem from our study. Since a currency is a symbol of sovereignty the scope for currency substitution estimated in this study suggests that the regulatory framework for rCBDCs is crucial as it determines how easily individuals can hold and transact digitally in different currencies across borders. One important implication is that new macroprudential tools might be needed to preserve the ability of countries to pursue independent monetary policies. Another implication is that, in a sufficiently liberal regulatory environment, cross-border holdings of rCBDCs might encourage more countries to adopt or stick to best practices in macroeconomic management and incentivize others who already do so to maintain these practices. Much will depend on whether policy makers allow markets to harness the promise of lower transactions costs and faster payments settlement