June 8, 2021

Central bank digital currency: the quest for minimally invasive technology

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Originally published on by Bank of International Settlements . Link to original report

( < 1 min)

CBDCs should let central banks provide a universal means of payment for the digital era. At the same time, such currencies must safeguard consumer privacy and maintain the two-tier financial system. We set out the economic and operational requirements for a “minimally invasive” design – one that preserves the private sector’s primary role in retail payments and financial intermediation – for CBDCs and discuss the implications for the underlying technology.

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Greater transparency for development finance institutions

( 2 mins) Development finance is critical to global development, including for the achievement of the sustainable development goals, low-income countries’ recovery from the pandemic, and the $100 billion commitment for climate finance. But to know whether finance and development goals are being met—and to keep institutions on track—we need better information on financial flows and how they impact development. Despite the scale of financing by development finance institutions (DFIs), few share ​detailed information on their private sector portfolios. This makes it difficult to assess their development impact and to foster learning within this space. Greater transparency will lay the foundation for more informed decisionmaking, more accountability, and better allocation of resources.
On November 3, the Center for Sustainable Development at Brookings will host a virtual event to create space for DFIs, civil society organizations, and the private sector to engage with key issues on DFI transparency. As part of the event, Publish What You Fund will launch the report “Advancing DFI Transparency – The rationale and roadmap for better impact, accountability, and markets.” A panel will discuss recommendations for greater global disclosure and how donors can better engage with national stakeholders and improve the publication of their development financing. The event will introduce a new DFI Transparency Tool.
Questions for the panelists may be submitted with registration. During the live event, the audience may submit questions by emailing [email protected] or by using the Twitter hashtag #DFItransparency. 

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Financial risk assessment and management in times of compounding climate and pandemic shocks

( 6 mins) More than 4 million people have died from COVID-19, and many others face long-lasting effects on their lives and livelihoods. While the full social, economic, and financial implications of COVID-19 are yet to be seen, millions have lost their jobs, and incomes in many countries have sharply declined. This raises concerns about sovereign debt sustainability and financial vulnerability in the medium term, particularly in developing countries and emerging markets.

The pandemic diverted the attention from another ongoing crisis: Climate change has affected the lives of more than 130 million people and resulted in over 15,000 deaths since the beginning of the COVID-19 crisis. Natural hazards such as tropical cyclones, floods, and wildfires are expected to become more frequent and intense in the coming years.
Understanding the economic and financial impacts of compound risks
With worsening climate change, compound risks (e.g., floods and droughts or pandemics and hurricanes hitting the same country shortly thereafter) could be more likely in the future. This should be the main concern for governments and financial supervisors because compound risks could exacerbate social and financial vulnerabilities. For instance, natural hazards destroying socioeconomic infrastructures, such as hospitals, provide a fertile ground for pandemics to spread, thus strengthening the pandemic’s socioeconomic toll and delaying recovery. In countries with limited fiscal space and capacity to respond, compound risk can lead to substantial fiscal impacts and slowed recovery.

The assessment and management of compound risks require a better understanding of how shocks of different nature (e.g., pandemics, climate change) are entering and passing through the economy. Eventually, we need to identify which assets and sectors are most vulnerable yet relevant in shocks’ transmission and amplification, in the economy and finance. This information would support policymakers and financial supervisors, answering the following questions “What are direct and indirect impacts of compound COVID-19 and climate physical risks, and how do they affect socio-economic and financial stability?” “Under which conditions can effective recovery policies be implemented?” “To what extent can countries strengthen their financial resilience to compound risks?”
Fit for purpose tools to assess compound risk
Answering these questions calls for macroeconomic models where heterogeneous agents—such as banks, firms, households, government, and a central bank—interact and adapt their investment and financing behavior, based on available information and on their expectations about the future. Consistently with the real world we live in, agents differ with regard to access to information (for instance, asset managers may have better information about financial market reaction to COVID-19 than car dealers) and risk management tools. Agents endowed with different access to information, preferences, and expectations, may diverge in their risk assessment and management strategies, with implications for the shock recovery.
Compound risk can amplify losses
A recent paper applies such a macroeconomic model to Mexico and shows that when shocks compound, such as the case of COVID-19 and natural disasters, losses could get amplified. Economic impacts are shock dependent, as a hurricane that might affect the supply side first by destroying productive plants and infrastructure differs from COVID-19 that enters as an aggregate demand shock by curbing people’s ability and willingness to spend money. The interplay between supply and demand shocks in the case of compound risk matters for the shock transmission through the economy and thus overall economic, private, and public finance impacts. This amplified impact is captured by the compound risk indicator in Figure 1, which compares GDP impacts of compound risks versus the sum of individually occurring pandemic and climate risk. A value of the indicator higher than 100 signals that the impact of the compound shocks is higher than the impact of the sum of individual shocks. In the case of a compounding strong climate physical shocks with COVID-19, non-linear amplification effects emerge.
Figure 1. Compound risk indicator for Mexico

Source: Dunz et al. 2021.
Drivers of shocks mitigation and amplification
Diverging preferences, expectations, and risk assessment are a main driver of compound shock amplification. Timely governments’ fiscal response is crucial to support the economic recovery and influence economic expectations. However, procyclical banks’ lending can counteract the effectiveness of fiscal stimulus by limiting firms’ recovery investments, creating the conditions for public finance distress (e.g., public debt sustainability). For instance, banks may revise their lending conditions to firms due to the uncertainty about the duration of the crisis, despite government and central banks’ actions (e.g., credit guarantees, recovery investments). By limiting the ability of firms to invest and of households to consume, procyclical lending can trigger persistent and nonlinear macroeconomic effects, such as higher unemployment and lower GDP (Figure 1).
Banks’ lending behavior is thus relevant for the success of government fiscal policies, and for their financial sustainability. Indeed, government’s recovery funds, financed by issuance of debt, are less effective in fostering the economic recovery in presence of credit and labor constraints. Coordination of fiscal and financial policies could help to tackle the complexity of the implications of compound risk, creating the conditions for functioning credit markets, and preserving sovereign debt sustainability.
Insights to build back better
Introducing compound risk considerations in fiscal and financial risk management can help governments and financial authorities build resilience to compounding shocks that could be more likely in the near future. Nevertheless, the assessment of compound risks requires an adaptation of the analytical tools that support policy making. Accounting for adaptive expectations and finance-economy interactions (e.g., bank lending conditions) that affect economic and financial agents’ response (e.g., investment, consumption) in times of crises could improve our understanding of how and why individual and compounding shock impacts might amplify. Such a new generation of macroeconomic models can thus support investors and policy makers in the assessment of risk and in the design of better-informed risk financing strategies. This, in turn, would enable the role of public and private finance in building resilience to compounding climate, pandemic, and other risks, for the benefit of the environment, the economy, and society.

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Focus – China’s continuing growth slowdown

( < 1 min) China’s era of rapid economic growth dated from 1979 until about a decade ago. Main drivers were: rapid growth in the working-age population; increased participation; employment; longer working hours; and rapid productivity growth. However, over

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CHINA: Power shortages lead to durable market reforms

( 5 mins) Severe power rationing has led to significant long-term reforms to China’s electricity pricing system that go beyond emergency stop-gap measures. Under the new system, coal-powered generators can pass on higher coal prices to electricity users;

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