Brace up the cryptocurrency

Context: Challenges in Monetary and Fiscal Policy will emerge when digital currencies gain traction. Policies must prepare for the transition.

Impact of advent of private digital currency 

• Dollarization of domestic currency: As domestic nationals lost faith in their own currency as a store of value, they shifted into and began transacting in US dollars for the security and stability it accorded. 
  • Greater the substitution into US dollars, the lower the potency of monetary policy.
• Adoption of private digital currencies as a medium of exchange: Larger the monetary base they cannibalise, the less potent will be domestic monetary policy in responding to business cycle needs and external shocks.
  • Because of aggregate supply is inelastic, demand shocks result in outsized price volatility. This, in turn, renders Bitcoin an inappropriate medium of exchange.
• Implications for monetary policy will be contained if cryptos are only used for “niche purposes”: Narrow cross-country transfers and remittances, which are then quickly converted back into local fiat currencies.
• Challenge to the global monetary system: Self-reinforcing network externalities involved, adoption would be rapid as digital currencies are bundled with other data and services. 
  • Prospect of digital currencies being transacted on large scales actively competing with fiat currencies.
• Global economic activity could eventually be re-organised into “digital currency areas” (DCAs) that run across national boundaries, characterised by their own digital currency and unit of account issued by the network owner, with the size of these DCAs dwarfing national economies.
• Owners of the networks would not necessarily run independent monetary policy, if privately issued “Global Stablecoins” are tied to a fiat currency.
• Local economy adversely impacted if “dollarization” happens: To profit-maximising network owner, who may not have any incentive to use monetary policy to smooth shocks or issue emergency liquidity when needed. Fate of economies to respond to shocks would be in the hands of private firms.
• Impact on fiscal policy: Greater the substitution into digital currencies the more the loss of seigniorage revenues to governments from the monopoly issuance of fiat currency. 
  • Fiscal revenues can also be adversely impacted by the increased tax evasion opportunities that crypto-currencies can facilitate.
• Increased substitution into cryptos reduces the efficacy of monetary policy, the onus on fiscal policy to respond to economic shocks will commensurately rise.
• Implications for the Rupee: To the extent that cryptos are mined abroad, demand for them will be akin to capital outflows. 
  • If cryptos begin to get mined onshore, they will induce capital inflows: It will increase capital account volatility and these cross-border flows circumvent capital flow measures, they de facto increase capital account convertibility, accentuating the policy trilemma that emerging markets confront.
• Direct impact the currency market: As the 2021 Global Financial Stability Report underscores, there must exist a triangular arbitrage between, like local Rupee-Bitcoin market, the Dollar-Bitcoin markets and the Rupee-Dollar market. 
  • Changes in the Rupee-Bitcoin markets will inevitably spill over into the Rupee-Dollar markets for markets to clear.

Conclusion: Macro implications of widespread crypto adoption are complex and interlinked. It will emerge and compound if and when unbacked private digital currencies are seen as viable mediums of exchange.

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