Central bank digital currencies: Solutions and challenges for policy and technology
World Economic Forum Conference
Paris, 22 October 2019, hosted by the OECD
Ladies and Gentlemen,
I would like to thank the World Economic Forum for the opportunity to present to you. Libra serves as a reminder that the case for international currencies is a strong one. The euro remains the most important contemporary regional currency. The SDR may have been the most ambitious though failed attempt to establish an international currency. My remarks will focus on the SDR to draw some possible lessons for libra or any other international currency project. While creating an international currency is relatively simple, making it work in practice is complicated. The SDR has faltered in large part because the governance structure guiding its design and issuance was inadequate.
The case for an international currency has been made for some time. Since we are in Paris today, U.S. President Andrew Johnson noted that at the Paris International Monetary Conference of 1867 "[…] the inconveniences of commerce and social intercourse resulting from the diverse standards of money value were very fully discussed […]."
The dollar has been serving as an international currency and remains the dominant currency in the international financial system. However, reliance on a national currency to manage international transactions is risky as international liquidity depends on a single source and problematic if national policy objectives of the U.S. diverge with the needs of the rest of the world. The dollar cannot effectively meet both national and international interests. This holds more so the less representative U.S. financial and economic conditions are of the international economy.
I shall offer some short remarks on the history of international currencies, then discuss briefly the motivation for adopting the SDR, outline a brief history of the SDR, reflect on the difficulties of agreeing on the main parameters of the SDR on the basis of the minutes of IMF Executive Board meetings, and discuss the implications of currency fluctuations for using a common currency. I hope my remarks will help highlight the importance of the governance arrangement for establishing an international currency.
The adoption of an international standard emerged prominently during the nineteenth century distinguishing currency unions, common currencies and common exchange rate frameworks. The main motivation was usually to foster international economic integration by reducing exchange rate related transaction costs.
The Latin Monetary Union of 1865-1927, comprising Belgium, France, Italy and Switzerland and later other countries established around the bi-metallic standard of a fixed silver-to-gold ratio of the French franc and required its members to mint gold and silver coins based on common specifications. The Scandinavian Monetary Union of 1873-1914 including Denmark, Norway and Sweden was based on the gold standard and of adopting fixed exchange rates across the national currencies.
Common currencies emerged with an aim to serve as cross-border settlement media. The Vienna coinage convention (Wiener Münzvertrag) of 1857 established a common coinage between the custom union (Zollverein) of the German States and Austria and adopting the crown (Krone) as a common gold coin and the 2 and 1 Thaler silver coins. The custom union coins were elevated to be accepted as legal tender in all local currency payments and common minting standards were enforced. The successful adoption of the union coins throughout the Zollverein laid the foundation for a common currency in Germany in 1871.
The Maria Theresa thaler, a prominent Austrian silver coin first issued in 1847, became a major currency used for trading through the Middle East and large parts of Africa. It may have been among the first truly international coin that long after it had been withdrawn in Austria in 1892 continued to be minted by private entities in several countries through the 1960s. The Maria Theresa thaler was not the only currency in circulation and its value may have rested in its complementarity with other currencies.
The 1867 Paris Monetary Conference, held during the World Exposition (Exposition Universelle), explored the possibility of adopting a world gold coin. The conference, with the participation of 20 countries including the United States, adopted an informal resolution though failed to ratify by which countries that had not adopted the franc system to include a coin with a simple conversion into the 5-franc gold coin as a common denominator in their national coin offerings. The conference achieved consensus that a future international monetary standard should be based solely on gold attesting that the gold standard was seen as the monetary standard of the future.
The gold standard emerged as the dominant international monetary standard during the 1870s. It implied that all currencies fixed to gold would be fixed to one another. Gold became the international settlement medium.
Fixed exchange rates
The importance of fixed exchange rates to facilitate international economic integration had been generally accepted. The collapse of the gold standard after World War I was followed by various attempts to restore exchange rate systems tied to gold. The adoption of the gold exchange standard with the 1925 Genoa conference offered somewhat greater flexibility and allowed foreign exchange, dollar and sterling, to complement gold as currency anchor and was maintained though not universally through the 1930s.
The gold standard and its derivatives served central banks as monetary policy framework to issue paper currencies or bank notes. It was meant to offer a credibility and disciplinary device. Central banks committed to reserve bank note issuance with gold thereby linking the expansion of bank notes strictly to gold availability. It gave confidence to the public that paper currencies could not expand unduly at the discretion of the central bank and thereby undermine monetary stability and fuel inflation. At the same time, its limitations, that is, gold expansion being contingent on external factors that may not coincide with domestic economic conditions remained at the centre of its critiques.
The 1944 Bretton Woods Conference restored the gold exchange standard after World War II, by which all currencies were fixed but adjustable to the dollar and the dollar was fixed to gold. The International Monetary Fund (IMF) was established to ensure exchange rate parities or par values were observed. The Bretton Woods system implied that the expansion of money and henceforth liquidity depended on the availability of gold or dollar central bank foreign exchange reserves.
The 1950-60s were marked by the mounting importance of the dollar to become the principal reserve asset of central banks. During the 1960s, the IMF became increasingly concerned about the slowing pace of reserve accumulation. By 1960, the dollar overtook sterling as the largest foreign exchange reserve. At the time, any rise in international reserves was mostly due to increased holdings of foreign exchange mainly dollars and it was feared that the accretion of dollars will soon abate leading eventually to a significant weakening of the structure of international liquidity.
The difficulty of using gold as a standard was recognised early. The expansion of money to support economic activity would depend arbitrarily on gold finds and mining technologies. The deflationary elements in the gold standard were well known. John Maynard Keynes stated as part of the objectives of his 1942 proposal of an international clearing union:
“We need a quantum of international currency, which is neither determined in an unpredictable and irrelevant manner as, for example, by the technical progress of the gold industry, nor subject to large variations depending on the gold reserve policies of individual countries […].”
Keynes encapsulates a fundamental motivation for adopting international currencies that are not tied to particular conditions often outside the interests of countries. This holds similarly for the dollar. The dollar is the currency of the U.S. and is meant to service its needs and the Federal Reserve is highly unlikely to subordinate its national policy objectives to the needs of the international economy. When U.S. national and international needs are congruent, this may not pose a challenge. When they diverge it does.
In 1965, the IMF included as part of its work programme the need for the creation of additional reserves. In 1967, the IMF began deliberations in earnest about a reserve facility based on “drawing rights in the Fund” and the Board of Governors, the highest decision-making body of the IMF, adopted a resolution for a “supplement to existing reserve assets.” In 1968, the IMF Executive Board, responsible for the daily operations of the IMF and represented by Directors and their Alternates from the different IMF member countries, recommended establishing a facility for “special drawing rights” (SDRs). By 1970, foreign exchange reserves overtook gold as the principal reserve assets with the dollar representing on average three quarters of central banks’ foreign exchange reserve holdings. In January 1970, the first SDR allocation was made. In 1971, the suspension of the dollar parity to gold ended the gold exchange standard and introduced generalised floating of the major currencies.
The SDR represents a claim on the foreign exchange holdings of other IMF member countries that have the obligation to accept SDRs in exchange of foreign exchange. The SDR mechanism is self-financing and levies charges on allocations which are used to pay interest on SDR holdings. If a country’s SDR holdings rise above its allocation, it effectively earns interest on the excess. If it holds fewer SDRs than allocated, it pays interest on the shortfall.
SDRs are held predominately by central banks in their accounts at the IMF and used almost exclusively in transactions within the IMF. The SDR is also a unit of account and all transactions of the IMF are accounted for in SDRs.
The end of the Bretton Woods system triggered a rethink about the role of the SDR and advanced the idea of a substitution account, that is, the exchange of existing reserve assets for SDRs. In 1972-74, the Committee of Twenty analysed the possibility of a substitution account based on a compulsory exchange of foreign exchange assets for SDRs. In 1975, the IMF debated a substitution account for gold to allow IMF member countries to obtain SDRs in exchange of gold. In 1979, after different iterations, the IMF reconsidered a substitution account to exchange dollars for SDRs. The idea attracted considerable interest and consisted of an account administered by the IMF that accepts deposits on a voluntary basis of eligible dollar-denominated securities in exchange for an equivalent amount of SDR-denominated claims. The account was seen to contribute significantly to promoting the SDR. In 1978, the IMF stipulated that the SDR is to become “the principal reserve asset in the international monetary system” and demonetised gold .
The valuation of the SDR attracted considerable debate and controversy. The SDR was originally valued as an equivalent weight in gold consistent with the par-value system. In 1969, its valuation was set equal to 0.888671 grams of fine gold equivalent to the value of 1 dollar, being the par value of the dollar, so that 1 SDR equalled 1 dollar. The collapse of the Bretton Woods System let since July 1974, of the value of the SDR being based on the market value of a basket of currencies.
In October 1971, a proposal to tie the value of the SDR to a weighted average of currency values was considered. The objective was for the basket to be relatively stable in purchasing power terms and that no single currency should have an undue influence on the value of the basket. The decision to base the SDR on a basket of currencies was taken at a meeting of the Committee of Twenty in January 1974.
The original SDR valuation basket had 16 currencies based on the criterion that the basket should be as inclusive as possible to reflect the diversity of the IMF membership. The currencies were chosen on the grounds of an international transaction criterion approximated by the issuing countries’ shares in international trade of goods and services of equal or greater than 1 percent in the period 1968 to 1972. The value of the SDR was calculated as the weighted average of the exchanger rates of the SDR basket currencies vis-a-vis the dollar. A modified weight was assigned to the dollar of about one third of the total to reflect its special role and importance. The SDR interest rate was initially set at 5 percent by the Fund in July 1974.
The SDR valuation remained contested throughout. Emphasis shifted away from the objective of the SDR being representative of the international transactions of IMF member countries towards strengthening and simplifying the SDR as a financial asset. Overarching concerns about the SDR interest rate gave way to considerations about the composition of the currency basket.
The deliberations of the IMF Executive Board illustrated the divergent views among IMF member countries:
Director Cross, U.S.: “the whole purpose of a basket had been to make the SDR an international reserve asset whose value would not depend primarily on the economic policy decisions of only one member government.”
The opposing views among IMF member countries about role and design of the SDR contributed to the waning support for the SDR. From the 1980s, the SDR fell into disregard and attracted only very limited interest amid a perceived lack of need to supplement existing reserve assets and concerns that further SDR allocations would be inflationary. There was no SDR allocation from 1981 through 2008. In 1980, the substitution account ideas were abandoned.
The SDR debate outlines the parameters that guide considerations for an international currency:
The objective of an international currency is to reduce currency-related transaction costs in international exchange normally associated with exchange rate fluctuations. Those can be significant. The nominal values of the national currencies of the 10 largest Facebook users comprising India, Brazil, Indonesia, Mexico, Philippines, Vietnam, Thailand, Turkey and the U.K. excluding the U.S. increased against the U.S. dollar, that is the currency depreciated, on a Facebook user weighted basis by 65 percent between 2010 and 2019. Differences in national currency movements are significant. The nominal value of the Turkish lira increased by more than 250 percent while the Thai baht remained stable vis-à-vis the dollar.
The large currency fluctuations may complicate international exchange. The use of a common currency instead seems to address the problem. However, exchange rates merely reflect underlying differences in domestic prices or inflation. If differences in inflation persist, the use of a common currency would hugely undermine the competitiveness of countries whose domestic prices increase faster than their partner countries’ ones.
The euro offers critical lessons of the effect of persistent divergence in domestic prices across countries using a common currency. Following the introduction of the euro in 1999, Greece and Spain, saw a significant appreciation of their real effective exchange rates, that is their nominal exchange corrected for differences in domestic prices weighted by the currencies of their international trade partners. Since Greece and Spain trade largely with other Euro Area countries, the currency appreciation weakened their competitiveness and led to a significant increase in their current account deficits. In contrast, Germany through 2010 maintained relatively stable domestic prices. Greek and Spanish goods became increasingly expensive relative to German goods. The divergence of domestic prices between Germany and Greece and Spain can be associated with the considerable imbalances among Euro Area countries.
International currencies that do not depend on vagaries of individual countries are highly desirable and should be international welfare enhancing. However, designing such currencies is complicated. The governance structure of the SDR has been inadequate to foster adoption and dissemination. To reach agreement in particular with a heterogenous group of representatives on the parameters of an international currency is hard amid diverging countries’ interests and willingness to subordinate economic policies to a fixed exchange rate. This renders the utility of an international currency ambiguous.
The fate of the SDR remains unclear. In March 2009, the SDR got a fillip with proposals by the Chinese and Russian authorities to establish greater reserve currency diversification based on the SDR. This was followed by large allocations of SDRs in August 2009 to accommodate additional international liquidity needs following the global financial and economic crisis. In October 2016, the inclusion of the renminbi in the SDR valuation basket promised some scope to sustain the momentum towards a renewed proliferation of the SDR.
Libra’s ambition to create a global currency is grand. The case for a global currency is a strong one. But, the best approach seems to be to establish a parallel currency used to meet certain transaction demands rather than to substitute national currencies (the Libra Association seems to be saying as much). This could be similar to the historical example of the Vereinsmünzen among the German States and Austria or the Maria Theresa thaler. Even so, where national currencies diverge significantly the use of a common currency remains hazardous. If the Euro Area, offering multiple layers for economic cooperation, finds it difficult to use a common currency amid persistent economic differences, any international currency project should take note. The risk remains that international currencies may only work in theory.
Boughton, J. (2001). Silent Revolution, The International Monetary Fund 1979-1989. Retrieved from Washington, D.C.: https://www.imf.org/external/pubs/ft/history/2001/index.htm
IMF. (1964). Gold and international liquidity EBD/64/85 10 July 1964.
IMF. (1965). Future work on international liquidity and related topics EBD/65/168 18 October 1965.
IMF. (1967a). The outline of a new facility in the Fund DM/67/58 15 September 1967.
IMF. (1967b). An outline of a reserve facility based on drawing rights in the Fund SM/67/69 29 May 1967.
IMF. (1968a). Board of Governors Resolution 22-8 SM/68/78 16 April 1968.
IMF. (1968b). Proposed amendment to the Articles of Agreement of the International Monetary Fund prepared pursuant to Board of Governors Resolution No. 22-8 SM/68/75 10 April 1968.
IMF. (1968c). Report of Executive Directors SM/68/38 1 March 1968.
IMF. (1969). The International Monetary Fund 1945-1965, Volume III: Documents. Washington, D.C.: International Monetary Fund.
IMF. (1970). Allocation of Special Drawing Rights EBD/70/4 6 January 1970.
IMF. (1971). Statement by Mr Lieftinck (BUFF/71/151) 27 October 1971.
IMF. (1974a). Interest rate on the SDR and rate of remuneration BUFF/74/66 5 June 1974.
IMF. (1974b). Interim valuation of the SDR SM/74/59 8 March 1974.
IMF. (1974c). Minutes of Executive Board Meeting 74/24 22 March 1974.
IMF. (1975). A Substitution account for gold SM/75/94 24 April 1975.
IMF. (1978a). Articles of Agreement. Washington, D.C.: International Monetary Fund.
IMF. (1978b). Minutes of Executive Board Meeting 78/12 30 January 1978.
IMF. (1979a). The SDR as a basket of currencies DM/79/86 26 November 1979.
IMF. (1979b). The SDR basket as basket of currencies (DM/79/86). Washington, D.C.
IMF. (1980a). Minutes of Executive Board Meeting 80/133 and 80/134 8 September 1980.
IMF. (1980b). Report of the Executive Board to the Interim Committee on a Substitution Account SM/80/89 15 April 1980.
Johnson, A. (1867, 3 December 1867). [Third Annual Message to Congress].
* Remarks are based in large part on a working paper issued with the London School of Economics entitled The SDR—A blueprint for libra?
1 Johnson (1867).
2 See Kuroda (2007, p. 91) for an explanation based on currency complementarity: “The [Maria Theresa thaler] alone could not mediate between buyers and sellers: it could work well only in association with other monies. The key to solve the mystery is the nature of the complementary relationship among monies in circulation side by side.”
3 IMF (1967a).
4 IMF (1964).
5 IMF (1969). Italics as per original.
6 IMF (1965).
7 IMF (1967b); IMF (1968b).
8 IMF (1968c); IMF (1968a).
9 IMF Annual Reports.
10 IMF (1970).
11 The SDR designation mechanism provides that in the event there is insufficient capacity under the voluntary trading arrangement, the IMF can ask member countries with sufficiently strong external positions to buy SDRs with freely usable currencies up to a certain amounts from member countries with weak external positions.
12 The Committee of Twenty was an ad hoc committee in 1972-74 made of representatives of the IMF Executive Board to review options for reforming the international monetary system; see e.g. Boughton (2001).
13 IMF (1975).
14 IMF (1980b).
15 IMF (1978a), Article VIII section 7.
16 IMF (1979a).
17 Proposal was tabled by Director Lieftinck (Netherlands) Director for Cyprus, Israel, Netherlands, Romania and Yugoslavia. IMF (1971).
18 IMF (1974b).
19 IMF (1979b).
20 IMF (1974a).
21 Director for Cyprus, Israel, Netherlands and Yugoslavia. IMF (1974c).
22 IMF (1978b).
23 Director for Afghanistan, Algeria, Ghana, Iran, Morocco, Oman and Tunisia. IMF (1980a).
24 Director for Germany. IMF (1980a).
25 Boughton (2001).
26 Xiaochuan Zhou (2009), “Reform of the international monetary system,” People’s Bank of China website http://www.pbc.gov.cn/english/detail.asp?col=6500&id=178, 23 March 2009; President of Russia (2009), “Russian proposals to the London Summit (April 2009),” President of Russia website http://eng.kremlin.ru/text/docs/2009/03/213995.shtml, 16 March 2009.