By Sameer Sharma
That the Bank of Mauritius (BoM) does not have an adequate balance sheet to implement credible monetary policy along with a clearly defined and quantifiable inflation targeting framework (or any framework for that matter) is evident. While it is interesting to see many articles in Mauritius about the need to increase interest rates, without a framework, such opinions are quite mute. However, what is less evident is that what the BoM is likely to do next when it comes to the creation of a Central Bank Digital Currency (CBDC), given its current situation, may get the central bank stuck into what is known as permanent loosening.
Mauritius does not lack pseudo experts
It is quite fashionable these days to throw terms like digital currencies around, and Mauritius does not lack pseudo experts who will gladly flatter such moves, but what actually really matters are the details.
As an example of pseudo expertise, one major business tycoon, in an attempt to side step the debate on higher taxes, recently spoke about using the funds of the Mauritius Investment Corporation (MIC) to help the poor. Whether such experts understand that printing money and injecting more liquidity make inflation worse, and not better, is another matter. Such is the level of debate, and the cultural tendency for some to speak about any and all topics as long as they do not get to contribute from their pockets themselves.
The level of debate in Mauritius has gone to the gutter with more and more people talking about the central bank printing money to solve inflation. There would also be balance sheet implications but such things no longer matter. We do not want to do anything about fiscal policy and reforms.
We even have politicians talking about using MIC money to help the poor since the tycoon came up with the grand idea. These same politicians talk about a weak BoM balance sheet and the ills of money printing one second, and speak about transferring MIC funds which are money printing the next. Populism has got out of hand. They confuse central bank balance sheets with traditional corporate balance sheets. Accounting and advanced economics are not the same fields.
The mechanics of a Central Bank Digital Currency
Getting back to the CBDC topic, the BoM has also not been holding any proper technical debates on how this would impact its balance sheet, how it would defend against cyber attacks, and nor has it addressed legitimate concerns about data privacy in a country where institutional independence remains fluid. The focus of this article is on the mechanics of how a Central Bank Digital Currency in the current context will lead to permanent loosening.
Allowing Mauritians to hold central bank deposits might considerably increase the size of the central bank balance sheet and pose the problem of which assets to hold against them. If CBDC deposits are remunerated and become another channel to transmit monetary policy, then the central bank will also need offsetting assets which generate higher returns to match these liabilities. Higher returns mean higher risks. If the MIC’s investment structuring skills are anything to go by, then we should be very concerned.
The composition of the BoM balance sheet, which is already atypical given the MIC, would continue to change. If a central bank purchases assets to offset these CBDC liabilities in the open market, it will need to inject liquidity into the system which has already more than 25 billion rupees in excess liquidity. Talking about any tightening of monetary policy in such a scenario becomes mute.
The introduction of a Central Bank Digital Currency will also impact the level of commercial bank deposits, and hence its current funding mix. Some smaller banks in particular would invariably witness rising funding costs.
A central bank purchasing government bonds (which is quantitative easing if bought on the secondary bond market) would reduce the supply of bonds in an already underdeveloped and highly fragmented bond market, and also affect interbank funding costs given its impact on overall liquidity. A meaningful shift from deposit funding to interbank funding and lending would be quite a change requiring closer scrutiny in managing counterparty risk by banks than they have been used to. In a nutshell, while the size and composition of its assets may not change, the composition of the liabilities of a commercial bank will.
Commercial banks might use their excess reserves to allow depositors to switch from bank deposits to CBDC deposits.
However, initial conditions matter especially if the banking system has excess liquidity and a central bank that has no balance sheet and seems to have been eager to include risky assets via the MIC. Introducing a Central Bank Digital Currency under a regime where the central bank has been purchasing high risk assets has non-linear effects. Mauritius has more than 25 billion rupees in excess liquidity in the system, which is already distorting the level of short term interest rates and credit risk pricing. When the MIC or tomorrow the central bank directly purchases risky assets, it will in effect create money for purchasing such assets.
Imagine now that due to rising inflation pressures, the central bank needs to tighten monetary policy and taper the level of excess liquidity in the system in order to bring short term market rates closer to the policy rate. Introducing a Central Bank Digital Currency in this context might impair such a tapering phase, as commercial banks might use their excess reserves to allow depositors to switch from bank deposits to CBDC deposits. This would render (part of the) loosening programmes quasi-permanent.
Two ways to interact with the CBDC
To be more technical, there are two ways in which commercial banks and the central bank will interact with the Central Bank Digital Currency. One way would be to transfer a unit of assets to the central bank, which would make the commercial bank lose one unit of deposits and one unit of assets. Any transfer of bonds or credit risky instruments would impact the duration and credit exposure of the BoM. The BoM would gain one unit of asset backing the CBDC liability.
The second more likely way, given the current excess liquidity context, would be for the commercial bank to reduce its amount of excess reserves held at the BoM. The commercial bank would hence lose an equivalent amount of deposits and reserves. The central bank would credit one unit of CBDC deposits which is a liability but also reduce an equivalent level of bank reserves. Deposits get used in the economy by the people versus these commercial bank excess reserves which stay at the central bank.
The larger the level of excess reserves and the weaker the BoM balance sheet, the more complicated things will be.
The assets of the central bank in this case would remain unchanged. It is not complicated to notice that all this could have significant implications on any potential reversals in the current loose monetary conditions. The larger the level of excess reserves and the weaker the BoM balance sheet, as is currently the case, the more complicated things will be. The balance sheet may be stuck in permanent loosening mode. In this case the BoM, not having a higher return asset to offset the interest bearing CBDC liability, will also have a profitability problem.
Whether the Bank of Mauritius and our politicians have even thought these things through is an open question, especially post transfers and given past one-sided deals of the Mauritius Investment Corporation, but a necessary one to ask.