Fabrizio Pagani: «Are Debt And Climate Transforming Central Banks?»

Central banks are increasingly weighing in on challenges facing our society, dramatically broadening their perspective beyond financial markets and banking, Fabrizio Pagani writes in his article for finews.first.

This article is published on finews.first, a forum for authors specialized in economic and financial topics.

Central banking is facing three pressing challenges: debt, digital and climate. We believe the response to these challenges by the major central banks will change the nature of monetary policy and the role of central banking in the economy and society at large.

Since the 2007/2008 Great Financial Crisis (GFC), central banks have enriched the toolkit of monetary policy by introducing new non-standard instruments and enhancing existing ones. Among these unconventional policies, quantitative easing stands out. Major central banks have engaged in quantitative easing (QE) in the years following the GFC and have made further, massive, recourse to this instrument in response to the COVID–19 pandemic.

«Existential questions loom over this debt»

So also the Federal Reserve (Fed), European Central Bank (ECB), Bank of England and Bank of Japan did. In the last decade, central bank balance sheets have grown dramatically. For example, the number of bonds bought by the Euro-system through its different programs (APP and PEPP) stood at around 4,000 billion euros in mid-April 2021.

More than 75 percent of the securities owned by the ECB are government bonds, the purchase of which will continue at a substantive pace until at least the end of March 2022, further swelling its balance sheet. Equally in April 2021 Fed-owned assets amounted to more than $7700 billion, with a striking ninefold increase since early 2008. The ECB and Fed will end up owning between 25 percent and 30 percent of their government's debt, and the Bank of Japan over 40 percent.

Existential questions loom over this debt, well beyond contingent issues about the length of the extension to the current purchase programs. Will central banks embark on its indefinite rollover, possibly extending the maturity? Will this debt eventually be made perpetual or even canceled as has been proposed? In the case of the European Union, will the ECB progressively replace national debt with a supranational one issued by the Commission under programs such as the Next Generation EU?

«A technological revolution is taking place: money could not remain unaffected»

Each central bank has its own mandate, culture and practices and these questions can, possibly, find narrow, technical answers according to each jurisdiction. However, there is a general interrogative on the long-term role that central banks will play vis-à-vis the increasing levels of government indebtedness and the rising amount of national debt which they own. Perhaps we have not yet reached a time to fully answer these questions.

In recent years, we have seen an acceleration in the pace of digitalization in all aspects of the economy and within society more broadly. A technological revolution is taking place: money could not remain unaffected. Indeed, it is not the first time money has undergone a radical technological transformation and each transformation, such as from gold coins to banknotes, has had its own challenges.

There is much confusion around the exact definition of the digitalization of money. It is a notion that includes different phenomena such as electronic payment systems, the most successful being the digital wallets of China’s WeChat and Alipay; the emerging array of fiat cryptocurrencies, such as the popular bitcoin and stable coins on the blockchain; and the possibility of central banks issuing digital currencies.

Central banks and governments globally are considering introducing central bank digital currencies (CBDCs). For some time, the Bank of International Settlement (BIS) has been trying to find clarity and provide some early taxonomy. Central bankers are eager to stress the difference between CBDCs and cryptocurrencies that they prefer to call crypto-assets.

«Reality is more complex»

We believe there is an emerging “official” view which broadly sees digital currencies relying on a central authority and being associated with a physical currency, such as the dollar or the euro. On the contrary, cryptocurrencies are considered closer to investment than to money and are «mined» or «produced» in a decentralized way by private players.

Reality is more complex. The development of private currencies is possible – bitcoin could soon be accepted as a means of payment by certain businesses. The dystopian risk of fragmentation, multiplication and competition of currencies could soon become reality, as is the possibility of the creation of privately sponsored international digital currency areas across national borders. Facing this threat, but also with the ability to use new tools to fulfill their mandates, central banks are more actively exploring whether and how to create digital currencies. A recent report on a Digital Euro by the ECB makes a compelling case for its pursuance.

The challenge for central banks will be to combine the fast-evolving world of digital technologies with the mandate of stability entrusted to them and descending from their mandates. Much preparatory work is necessary and there are numerous issues to be solved, e.g., access, privacy, safety, anti-money laundering, possible restrictions in use, remuneration etc.

«Monetary policy could be transformed»

The digitalization of the currency opens a realm of possibilities and its introduction could have wide ramifications. Monetary policy could be transformed. Looking into CBDC remuneration, effects could be manifold. For example:

• the transmission of interest rates to household deposit rates could become more direct;
• the case for negative interest rates, what economists call the «zero lower bound problem» could disappear;
• remuneration could be tiered, with different interest rates applied in different cases.

On the latter point, which could open fascinating policy avenues, the ECB writes that CBDC would «allow the Eurosystem to pay less attractive interest rates on large holdings of digital euro or on holdings by foreign investors in order to discourage excessive use of the digital euro as an investment or to mitigate the risk of attracting huge international investment flows».

Obviously, the banking system will also be deeply affected, with the possibility of drastic disintermediation of commercial banks. At the current stage, no final decision of issuing CBDC has been taken by any major central bank. In this changing and uncertain environment, central banks – and governments – need to act and react fast if they want to retain monetary sovereignty. Perhaps CBDCs are becoming an inevitable necessity, on top of being useful tools.

«Fighting climate change appears far beyond the remit of central banks»

Climate change is a major threat to mankind. Its impact on economic activities cannot be underestimated. Fighting climate change appears far beyond the remit of central banks. However, climate change has an impact on the economy, including on financial and even price stability. There is, therefore, growing consensus that central banks, without being the main actors, must play a role. This role, which is advocated by many as part of the mobilization of the whole of society against climate change, could cut across monetary policy, financial stability, prudential regulation and supervision.

In 2019, the ECB launched a strategy review and put climate change on the list of topics to be addressed. The review has not yet been concluded, but the ECB is already taking some actions on its banking supervision functions, to contain climate-related risk, on the monetary side and on its non-monetary policy portfolio, to facilitate the fight against climate change. In particular, since early 2021, bonds with coupons linked to sustainability performance targets have become eligible as central bank collateral for Eurosystem credit operations and for asset purchase programs.

«There are powerful tensions around the traditional mandates of central banks»

A similar mechanism has also been introduced by the People’s Bank of China. A harder stance has been taken by the Swedish Riksbank which, since January 2021, has the option of applying negative screening to its purchases of corporate bonds and excluding bonds from issuers that do not comply with sustainability standards. Also, in this case, central banks must find new paths which, without compromising their market neutrality or going ultra vires, allow them to take material action against climate change.

There are powerful tensions around the traditional mandates of central banks. These tensions run through the unconventional monetary policy instruments in place since the Great Financial Crisis, the fast-paced technology developments that are changing the nature of money and the role society is expecting central banks to play in fighting climate change.

«The ultimate challenge will be to reconcile these new functions while retaining full credibility»

They are somehow testament to the ever-more relevant role that central banking is assuming in our economies. Central bank perspectives are de facto broadening beyond financial markets and banking and societies seem more and more comfortable with this new role. The ultimate challenge will be to reconcile these new functions while retaining full credibility by acting within mandates. Ultimately, the challenges faced by central banks mirror those of our society.

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