Digital Monetary Solutions for Small Countries
This paper is focused on the financial and monetary economies of small countries.
The research described in this paper is based on the economic theory of Prof. Perry G. Mehrling, professor of economics at Barnard College in New York City. According to Prof Mehrling (1), in the current global monetary system, a nation’s central banks occupy a special place at the top of the hierarchy of financial instruments and financial institutions. As such, they play a key role in the short- and long-term stability and success of a country. The responsibilities of today’s central banks are threefold: lender of last resort, regulation and supervision, and monetary policy for macroeconomic stabilization (1).
Some small countries do not have a central bank, and, in this case some other institution is responsible for making the country’s monetary policy and for regulating and supervising its commercial banking system.
The World Bank classifies 50 countries as small countries. These have populations of less than 1.5 million, and some are rich, whereas others are poor. Some, such as Luxembourg, are high-income countries whereas others, including Djibouti, are low-income ones. Most of the small states are islands or are widely dispersed multi-island states.
The middle- and lower-income small states face a common problem: constraints due to their size. Because of their tiny populations, these states cannot spread the fixed costs of government or business over a large number of people — that is, they cannot achieve economies of scale as can larger states. These diseconomies of scale, as economists’ term them, result in high costs in both the public and private sectors (6).
Their small size also seems to be reflected in a number of macroeconomic characteristics that they have in common:
• Narrow production base: All face problems in establishing a competitive economic base, where they typically compete in only one or two goods or services, leaving them vulnerable to ups and downs in a handful of industries.
• Big government: Measured by the ratio of government expenditures to GDP, small states tend to have relatively larger governments than do larger states.
• Poorly developed financial sector: About half of the small states have gained prominence as offshore financial centers. However, financial institutions in such offshore financial centers typically serve nonresidents, and so, in general, the domestic financial sectors of small states lack depth, are concentrated, and do not provide their citizens with adequate access to financial services. Their financial sectors are dominated by banks whose high lending rates often hinder investment. Also, because the private sectors in small states are so tiny, commercial banks often end up financing the country’s government, thereby risking their soundness by becoming heavily exposed to one borrower. This also complicates economic policy actions meant to lower government debt. For instance, in the highly indebted Caribbean countries, commercial banks and nonbank financial institutions hold two-thirds of domestic public debt. In contrast, government debt in larger countries is usually owned by a variety of individuals and by financial and nonfinancial institutions.
• Fixed exchange rates: Small states are more likely than larger ones to peg their exchange rates to another currency. The ability of small states to conduct monetary policy is also more limited. Five of the 13 small states in the Asia-Pacific region, for example, do not have a central bank.
• Trade openness: Small states are also more open to trade, and trade-to-GDP ratios tend to be much larger in smaller economies than in larger ones with similar policies. Small states also seem to have somewhat lower trade barriers. A high degree of trade openness often leaves small states vulnerable to shocks from terms of trade (i.e., the prices of exports compared with the prices of imports).
• Natural disasters: Natural disasters annually cost microstates a great deal of money, and many are islands that face particular challenges due to climate change.
• Cost of living: The remoteness of many of these countries can be a problem because the paucity of arable land makes them dependent on imported foodstuffs, whose importation can be very expensive.
Jahan and Wang (2013) conclude that small states can, however, compensate for their size-related disadvantages by taking steps that will allow them to exploit their advantages and offset their disadvantages. Of these steps, in general, sound economic policies matter most.
The evolution of Money and Banking
In 1694, the Bank of England was founded as a profit-making company whose purpose was to purchase government debt. Using bonds as backing, it issued bank notes, thus receiving both the interest on the bonds and the seigniorage of the bank notes. Other European central banks followed suit, prompted by similar objectives: to deal with monetary disarray and to aid in government finance. Early central banks issued private notes which served as currency, and they often had a monopoly with respect to the issuance of such notes.
While these early central banks helped fund the government’s debt, they were also private entities that engaged in banking activities. Because they held the deposits of other banks, they came to serve as banks for bankers, facilitating transactions between banks and providing other banking services. They became the central repository for most banks in the country’s banking system because of their large reserves and extensive networks of correspondent banks. These factors allowed them to become the lender of last resort in the face of a financial crisis. As such, they were willing to provide emergency cash to their correspondents in times of financial distress.
The first banks appeared in the United States in 1791–1811 and then in 1816–36, and these were followed by the Independent Treasury, which functioned from 1846 to 1914, when the Federal Reserve System replaced it. These institutions, together with the Suffolk Bank and the New York Clearing House, exercised important, central banking functions before the creation of the Federal Reserve System in 1913. This change also contributed to a change in the behavior of central banks and their interactions with economists and politicians. Central banks’ behavior has shown considerable continuity in the influence of incentives and their interest in the stability of financial markets.
The gold standard, which prevailed until 1914, meant that each country defined its currency in terms of a fixed weight in gold. As required by their charters, central banks held large gold reserves to ensure that their notes could be converted into gold. Within each country, the hierarchy of financial instruments was fairly simple: gold was the ultimate money. Beneath gold in the hierarchy of instruments were national currencies, which promises to pay on demand gold and which were viewed as liabilities on the balance sheets of a central bank. Underneath that were bank deposits, which are promises to pay currency. Finally, underneath deposits in the hierarchy are all other kinds of credit.
Because the price level was tied to a common commodity whose value was determined by market forces, expectations about the future price level were tied to it as well. Early central banks were therefore strongly committed to price stability. They did not worry too much about the stability of the real economy, however, as they were constrained by their obligation to adhere to the gold standard.
A first shift in the monetary system came during the financial crises of 1825, 1837, 1847, and 1857, when the central banks were more interested in protecting their gold reserves than in being the lender of last resort. However, the banks were forced to subsume their private interests to the public interest of the banking system as a whole and began to lend freely on the basis of any sound collateral offered. As a consequence, no financial crises occurred for nearly 150 years after 1866, and it wasn’t until August 2007 that the country experienced its next real crisis.
The importance of the balance sheet
A simplified balance sheet of a generic bank has assets such as loans, securities, and cash and liabilities such as deposits and other forms of borrowing. Banks face two main challenges. One is solvency, in which the value of assets an organization owns is greater than the value of its liabilities so that its net worth is greater than zero. The solvency of an organization depends upon the market value of the assets on its balance sheet and that of its liabilities. However, banks differ significantly from other corporations because of the issue of liquidity. While banks that are insolvent can continue to survive for a long period of time, liquidity issues can very quickly cause a bank to close its doors.
In a normal market, the money market regulates itself perfectly to overcome liquidity issues. However, in a crisis, this is not the case, as was demonstrated in 2007 when central banks had to step in as the lender of last resort.
Many instruments and systems were developed and created to overcome these issues during both normal times and times of crisis. There are mainly two categories in the monetary market: institutions and instruments.
Until about 1950, there were mainly three type of institutions: the private sector, the banking sector, and the central bank. Today, however, there are many more types of participants, many having overlapping roles, and these are listed in the table below. All operate on a national basis, but many also do so on a global basis.
In small countries, financial institutions encompass a wide range of institutions, including commercial banks and other deposit-taking institutions (DTIs) such as credit unions, finance companies, trust and mortgage companies, and building societies, all of which offer traditional deposit and loan facilities to both households and firms. While these institutions are not sophisticated by international standards, they complement their physical branches by providing access to banking services through technologically-based products such as debit cards, credit cards, internet banking, and mobile payments. These deposit-taking intermediaries are supported by development banks, which engage in providing long-term funding to the private sector, and by life and general insurance companies. However, not all of these institutions exist in small countries.
Credit bureaus are still in their embryonic stage, as small countries seek to enhance their ability to better manage credit risk.
Financial markets and instruments
Two dimensions describe the use of financial instruments: there is elasticity and there is discipline (quantity and quality). In a boom, quantities increase (i.e., the quantity of credit increases) whereas in a crisis, deleveraging occurs (i.e., quantity of credit decreases). With respect to quality, in a boom, credit begins to look like money and moves up the hierarchy of financial instruments. Forms of credit become much more liquid and so much more usable as an instrument with which to make payments.
Below is a table that lists the different instruments that are available in a country like the United States:
In 2016, the Caribbean Centre for Money and Finance of the University of the West Indies published an extensive report (2) that includes an overview and comparison of the Caribbean financial markets. The report’s findings are applicable to most other small countries.
Financial markets in small countries are shallow with an emphasis primarily on the credit market and, in addition, slightly less active equity, bond, and foreign exchange markets. Not all these countries have fully-fledged stock markets as companies continue to rely on bank loans and, in some jurisdictions, on corporate bonds to finance their activities. Government securities dominate the domestic bond markets, and, while data are limited, it is evident that there are very few private sector bond listings. The table below summarizes the situation:
A central bank’s roles of lender of last resort and financial policy maker are extremely important, not only to support the economy in times of crisis but also to create a framework to encompass the country’s financial instruments and institutions, respectively. Governments lacking a central bank will not be able to achieve these objectives.
The need for modern payment systems to improve efficiency and reduce risk in the payment process has also been recognized but the limited volume of such transactions would often be insufficient to support enhancements to the current payment systems. In addition, while many countries now possess small stock exchanges, not all have established centralized securities depository systems to facilitate the transfer of securities.
In times of serious crisis, when more is needed than simply trying to influence the economy around its edges and liquidation events are occurring, the central bank must implement extreme measures to avoid a liquidity spiral. For example, to avoid major problems in 2007, several central banks, including the US Federal Reserve Bank, had to deal with asset prices by buying mortgage-backed securities. That is something that the governments of small countries cannot do, and therefore they require a different solution for situations such as this.
Two examples highlight the issue where not enough elasticity was available to overcome a crisis. Both occurred 2017 in the Caribbean because of Hurricane Maria. In Dominica, the hurricane caused substantial damages and the country was forced to obtain loans from the World Bank to restore agricultural livelihoods and rebuild homes. The other example is in relation to the tourism industry. In most of the Caribbean islands, the hotels were closed because of damage suffered as a consequence of the hurricane. Most hotel employees were therefore laid off, resulting in high unemployment, reduced tax income, and reduced income from tourism.
To handle situations such as this, the central banks of small countries such as those in the Caribbean (with their limited instruments, markets, and institutions) need to be brought to a level such that they can act quickly in crises such as the aftermath of Hurricane Maria. Blockchain technologies are a possible means whereby this can be achieved.
The following lists financial instruments that are based on blockchain technologies.
Whether the loans are secured or unsecured, the lending process itself has changed in the last 20 years. During the last financial crisis in 2007, banks had to lay off many employees and simultaneously automated their lending processes and procedures, which can be incorporated into smart contracts. Smart contracts are a way to implement business logic in a trustless way and enable lenders to validate transactions, verify the legitimacy of counterparties, and perform routine account administration tasks almost instantaneously, thereby reducing costs and accelerating the speed of the process. With smart contracts, no third party is needed for background checks or proprietary credit ratings. By design, the very nature of loans built on a distributed ledger is trustless, thus making the transfer of ownership of an asset possible, without the need for an intermediary such as a bank. This attribute could help revive peer-to-peer lending practices.
The benefits, particularly for small countries and their private citizens and their small-to-medium-enterprises (SMEs), would be significant, as access to credit is often difficult and expensive in these countries. As an example, use of these could enable governments to directly subsidize housing projects; a smart contract (created by a bank or central bank) would take care of the whole process, including making the payments. The government would need only to set the parameters, and the smart contract would take care of the rest.
A stablecoin is a cryptocurrency pegged to a stable asset, such as a fiat currency like the U.S. dollar. Stablecoin prices correspond to the value of the pegged asset, thereby distinguishing them from other cryptocurrencies (e.g., Bitcoin), whose price is driven by market dynamics.
Stablecoins are crypto-assets that maintain a stable value against a target price (e.g., the U.S. dollar). Stablecoins are designed for any (decentralized) application that requires a low threshold of volatility to be viable on a blockchain (3). There are several stablecoins in existence; Tether, with a daily trading volume of over $US2 billion, is the most prominent one.
The use of stablecoins pegged to a fiat currency would make possible international payments.
Coinbase and Gemini recently launched stablecoins (USDC and Gemini Dollar, respectively) that are regulated in the US and are audited on a monthly basis, thus minimizing counterparty risk. They are pegged 1:1 to the U.S. dollar and so can be easily converted to a fiat currency.
With such a coin, international payments (regardless of their amount) are possible 24/7 and, in the case of the Gemini Dollar, at the speed of the Ethereum blockchain. Therefore, use of this technology would enable international payments to be made from a computer without the need of using a bank as an intermediary.
In 2016, migrants living in different parts of the world sent more than US$570 billion (4) to their home countries, using a money-transfer market dominated by the top three (Western Union, MoneyGram, and Ria). Such transfers are expensive, take time, and require a lot of paperwork. Average remittance costs average around 7% but, on the high end, (e.g., remittances to South Africa) run as high as 16%. Banks are the most expensive means of making such remittances, with an average cost of 11% (5).
Blockchain technology is perfect for this industry, and several companies/projects already offer this service at a fraction of the cost of banks: Abra, BitPesa, Coins.ph, and Bitinca, to name just a few. These have been servicing several countries for some time now. Users need only access to a computer or phone to use them.
In a crisis, a country needs to react quickly to avoid an escalation of problems. For example, a natural disaster requires a fast reactivation of agricultural activities. In large countries, organizations having budgets that enable them to react quickly can intervene (for example FEMA in the US). However, small countries lack this type of rapid response. For example, farmers in such countries will have no insurance and so cannot immediately begin farming following a crisis. Thus, the government has to apply for loans or grants, and the money is distributed through banks (creating further delays and increasing the costs), as shown in the current process below:
The following scenario is possible using blockchain technologies. The government identifies agricultural suppliers, farmers, and the needs of the farmers and incorporates process and variables into a smart contract. A farmer can then go the agricultural supplier and receive the goods but will not need to pay the supplier as payments will be handled through the system directly. The blockchain process has multiple benefits: the risk of corruption or the risk of money disappearing are minimal, the whole process is transparent from the government’s point of view, fast and direct solution to problems.
The discussion above employed farming as an example; the process described above could be applied in many other areas.
Funding of small projects
In most small countries, a shortage of long-term, local-currency financing for small-scale projects impedes local economic development. Inadequate fiscal transfers, lack of (for the project) skilled labor, little own capital and low creditworthiness make it difficult for local governments to fully fund projects on their own.
NGOs, countries, private donations, foundations, funds, and other organizations may offer to fund projects. However, the process of applying and receiving these funds may take a long time, may not be certain, and is often linked to conditions (7).
Project funding using cryptocurrency-based solutions will most likely become a popular way to fund these types of projects. As a way for a cryptocurrency project to raise money, it may host an event in which it sells part of its cryptocurrency tokens to a global audience in exchange for money. This event usually takes place before the project is completed and so helps fund that project’s expenses until launch. The proceeds will also help to fund projects after the launch.
The most popular types of projects (tokens) are as follows:
· Fungible tokens that are interchangeable with another of an equal value; these tokens are not distinguishable from one another. Fungible tokens are for regular transactions and standardized exchanges of value.
· Non-Fungible tokens that are used to determine ownership of a digital asset. Example: Land registries and home ownership “on the blockchain” are common examples of a digital representation of a non-fungible token.
· Equity tokens: In this case, token holders receive dividends or fixed commissions and can also be able to take part is company decision making.
National currencies on a blockchain
Adding a national currency onto a blockchain will have several advantages, and it is only a matter of time before countries will begin doing so.
A national cryptocurrency is durable, as it exists as a ledger entry backed up on thousands of computers worldwide.
A national cryptocurrency is fungible. Each national cryptocurrency is worth the same as every other. It is recognizable, and every national cryptocurrency wallet can quickly attest whether the national cryptocurrency is legitimate or not. A national cryptocurrency cannot be counterfeited.
One of a national cryptocurrency’s greatest attributes is that it is highly portable. It can be sent anywhere at very little cost. It moves across borders with ease, because it has no concept of borders and it has no physical body that can be blocked or apprehended. It is the only form of money which can be moved any significant distance without trusting a third party.
A national cryptocurrency also possesses an important attribute: it can be programmed to enable all kinds of economic activity, often without a middleman escrow agent or human arbitration of any kind. Thus, the program operates without participants having to trust any third party. This is impossible with fiat currency, and in a digital age it will become one of a national cryptocurrency’s most important advantages.
Security tokens are tokens that are generally backed by a real asset such as equity, shares, or commodities and their holders can be granted ownership rights or shares of the company. Security tokens are tradable financial instruments with monetary value. Security Tokens bring a number of improvements to traditional financial products by removing the middleman from investment transactions:
International: Generally, when it comes to early stage investment, it is usually reserved for a limited subset of investors in a particular region. With security tokens, investments are open to anybody from any geographic region. A small retail investor in Africa can just as easily buy into a company than a New York based VC firm can.
Decisions: It is possible to structure the funding in a way that it links decisions to certain achieved milestones. The company will receive part of the investment only once they achieved specific objectives. This ensures investors can link the success of the company to their investment. Through smart contracts the process is fully automated and immutable.
Fractionalized ownership: the idea that an asset no matter how big or small can be broken into specific pieces, will give investors more diversity and better exposure in their portfolio.
Trading: Being able to get access to something that is easily tradable will increase the number of investors. In addition, settlement time for an overseas trading account is significantly reduced, tokens can be traded 24/7/365, there is more liquidity, higher transparency and storage of them is easier.
New derivatives and instruments. This is going to happen in a far more transparent manner than the current derivative system. There are asset classes that previously have been unable to become securities but now can, because of the properties of blockchain technology.
Central bank crypto assets
Many central banks across the globe hold gold as one of their reserve assets in order to hedge against periods of market unrest and for instances when they need to quickly liquidate their assets. Although no other asset is more liquid than gold, gold also has its downsides: it is difficult to hold (physically) and difficult to transport and the price of gold is volatile. Except for price volatility, Bitcoin or a basket of cryptocurrencies does not have these issues. It is easy to hold, and transfer and it cannot be changed. Moreover, it is highly liquid and can easily be converted into other currencies.
The president of the European Central Bank has publicly stated (8) that European banks could hold positions in Bitcoin, and several central banks in Africa have already started holding Bitcoins as an asset.
(1) Mehrling, P. (2014). Why Central Banking Should Be Re-Imagined. BIS Papers. In Bank for International Settlements (ed.), Re-Thinking the Lender of Last Resort, Vol. 79, 108–118. https://www.bis.org/publ/bppdf/bispap79i.pdf
(2) Caribbean Regional Financial Stability Report 2015. Caribbean Centre for Money and Finance, The University of the West Indies, St. Augustine, Republic of Trinidad and Tobago.
(3) Sexer, N. (July 24, 2018). State of Stablecoins, 2018. Consensys. https://media.consensys.net/the-state-of-stablecoins-2018-79ccb9988e63
(4) Pew Research Center (January 23, 2018). Remittance Flows Worldwide in 2016. http://www.pewglobal.org/interactives/remittance-map/
(5) The World Bank (IBRD-IDA) (September 2018). Remittance Prices Worldwide, Issue 27. https://remittanceprices.worldbank.org//sites/default/files/rpw_report_sept_2018.pdf
(6) Jahan, S., & Wang, K. (September 2013). A Big Question on Small States, Finance & Development, Vol. 50, №3. https://www.imf.org/external/pubs/ft/fandd/2013/09/Jahan.htm
(8) CCN (February 8, 2018). European Banks Could Soon Hold Bitcoin, Admits ECB President. CryptoCoinsNews. https://www.ccn.com/european-banks-soon-hold-bitcoin-admits-ecb-president/
(7) Akuffo, N. O., Rockson, I., and Annan, G. (2018). Challenges of Managing Grants in Developing Countries. https://www.srainternational.org/sites/default/files/pictures/OyeAkuffo_Final_Poster.pdf
(9) 2018 November 19 — Volume.2 Issue.45 IMF Explores Evolving Forms of Money, Prospects of CBDC