Central banking: embracing change

Speech by Mr Agustín Carstens, General Manager of the BIS, at the People's Bank of China, Beijing, 22 May 2024.

Introduction

It is a great pleasure to be here today at the People's Bank of China (PBC). I want to thank Governor Pan Gongsheng for inviting me.

The PBC joined the Bank for International Settlements (BIS) in 1996 and since then has become an important member of the BIS community. I look forward to further deepening the partnership that we have built over this period.

During my visit today, I am keen to hear about the changes under way in China as the economy transitions to a new growth model. I am especially interested in learning more about China's use of digital technology to deliver a more innovative and efficient financial system.

Central banks today are facing several transformative changes. In my remarks, I will emphasise that central banks must embrace these changes. Central banks play unique roles in the economy and society. To perform these roles successfully, central banks need to seize the opportunities offered by changes in environments, behaviours and technologies.

Roles of central banks

A central bank's foremost role is as an issuer of money. This "public" money serves as the unit of account and as the anchor for "private" monies. The fact that commercial bank deposits are backed by central bank reserves and can be converted easily into cash or other forms of money at par is at the core of why people readily deposit their earnings and savings in banks. This singleness of money is no coincidence. It stems from time-tested institutional arrangements – an often-underemphasised achievement of central banks.

A central bank's role as issuer is inextricably linked to its duty to maintain the value of the currency. This instils trust in money. Users accept money today because they trust that the money will be valued and thus accepted by others tomorrow. Trust therefore ensures that money can serve as an effective medium of exchange. In other words, as I have previously said, trust is the soul of money and central banks are its best guardians.¹

Central banks serve the public interest in a number of other ways as well. For example, they also maintain the safety and integrity of payments. They provide the infrastructure that, together with a sound legal framework, facilitates rapid settlement. Settlement on the central bank balance sheet is the ultimate guarantee of finality in financial transactions.

Finally, central banks safeguard financial stability. As the lender of last resort, they ensure that funding or liquidity shocks do not endanger the functioning of the financial system. Some central banks also regulate and supervise individual financial institutions to pre-empt excessive risk taking.

Macroeconomic changes

In performing these roles today, central banks are facing transformative changes in numerous areas. I will focus on two of these: changes in the macroeconomic environment, and the digital revolution. Naturally, the nature of these changes and the attendant challenges vary across economies.

In China, the challenges facing its property sector have provided an impetus to the transition from a growth model underpinned by heavy reliance on investment, particularly in real estate, to a more balanced one, led by consumption and innovation. This transition will be long and complex, requiring reforms in areas ranging from the social security system to the business climate. Recent policy announcements illustrate authorities' commitment to that journey. Delivering these reforms will ultimately raise productivity and put the economy on a path to higher-quality, sustainable and inclusive growth.

Outside of China, a transition is also under way, but of a very different nature. The inflation outbreak that followed the Covid-19 pandemic and the onset of the war in Ukraine was a stark reminder of how quickly the macroeconomic environment can change. The trust that central banks had gained around the world over many years in keeping inflation at bay could have been lost if society had started to doubt their commitment to price stability. Some generations experienced for the first time the risk of the economy transitioning to a high-inflation regime. Once that transition starts, it can become increasingly difficult to stop. Therefore, to restore price stability, it was necessary and appropriate for central banks to tighten policy decisively through higher interest rates.

Inflation has waned relative to its recent peak. In Europe and much of Asia, inflation is now near or at central banks' targets. Some of this reflects the resolution of pandemic-era supply distortions. Much credit also goes to monetary policy. As a recent BIS study showed, if central banks had not tightened monetary policy forcefully in response to the inflation surge, then we would have confronted more entrenched and persistent inflationary dynamics.²  

But lower inflation is not low inflation. In some economies, inflation is still above target, partly due to stickier services inflation and volatile food inflation. Thus, a tight stance may be needed for a long time because only through resolve, perseverance and success can trust in money be preserved.

As inflation dynamics across countries have diverged, so too have expectations about the path of interest rates needed to bring inflation back to target. This is complicating policy trade-offs in many economies, including via exchange rate movements.

In response to such trade-offs, central banks in Asia, including the PBC, have adapted their macro-financial stability frameworks. A report last year by a working group under the BIS Asian Consultative Council documented how differences in economy-specific characteristics justified varied policy responses to the global monetary tightening in 2022.³  The report explained how central banks successfully used a combination of tools, including interventions in foreign exchange and domestic bond markets, to deal with the unusual combination of shocks. Going forward, the divergent inflation dynamics we are experiencing today highlight the need to continually reassess the right policy mix, including the flexibility of the exchange rate.

Another, longer-term change in the macroeconomic environment is high levels of public debt. If used appropriately, public debt allows governments to function effectively. Yet, it is important that public debt is, and is seen to be, sustainable. An increase in the likelihood of default can compromise the stability of the financial system. Any hint that the government might resort to central bank financing to meet its financial obligations can threaten monetary stability.

The low interest rate environment of the 2010s flattered fiscal accounts in many economies. This environment might not return. While estimates are noisy, factors such as shifts in the savings-investment balance – including due to demographic trends – and a more inflationary environment might have raised r* and perceptions of it.⁴  In many economies, therefore, fiscal consolidation is needed today. It is needed not only for fiscal sustainability, but also to preserve trust in and the effectiveness of an economy's macro-financial stability framework. Achieving this goal is challenging, not least because of the involvement of multiple authorities and political economy concerns. These are not insurmountable problems, but they require better coordination and consistency across policymakers.

Digital revolution

The next change that I want to discuss concerns the digital revolution.

Digital advances have far-reaching consequences for the financial system. In our personal lives, QR codes and mobile apps have improved the efficiency of payments. Use of data can improve credit assessment. Financial services have become more user friendly and affordable – as well as more accessible. Both financial inclusion and financial engagement have, therefore, improved.

That said, the increased digitalisation of financial services also has costs. These include cyber risks, the possibility of more sophisticated frauds and scams, and data governance and privacy concerns. Furthermore, buy-now-pay-later services and smartphone lending apps are known to encourage excessive spending and indebtedness. All of this can hurt the financial health of some users.⁵

The digital revolution is also affecting the organisation of financial institutions. There are inherent economies of scale and scope in the digital provision of financial services and data generation. This includes network effects. They heighten the risk of some players becoming too-systemic-to-fail as well as of a decline in consumer choice as major players become omnipresent. A related issue is that central banks increasingly need to deal with non-traditional players, such as technology companies offering novel financial products. These players are often outside the financial regulation perimeter. They might exploit gaps in regulation, and some may assume opaque and excessive leverage. In some cases, a lack of clarity regarding which authority should oversee such players can lead to a disjointed policy response or regulatory arbitrage.

Against this backdrop, as overseers of the financial system – especially payments – central banks face a tough balancing act. On the one hand, they must ensure that any innovative product or service that comes to the market is compliant and does not pose undue risks to the financial system. On the other hand, being too restrictive can stifle innovation or push it into the shadows.

Policymakers are finding ways to strike a balance. One way is with regulatory sandboxes, which can be used to test innovative technologies within a well-defined space. Korea launched its regulatory sandbox for fintechs in 2019 and since then has selected 153 initiatives. In Hong Kong, a sandbox will help explore use cases for the eHKD, Hong Kong's pilot retail central bank digital currency (CBDC). Another way is with special licences dedicated to novel business models or non-traditional players. For example, in India a payment licence is available to both banks and non-banks. This has promoted a diverse payment ecosystem.

More generally, the principle of "same activity, same risk, same regulation" can ensure a level playing field while also supporting innovation. Furthermore, mandating interoperability can help avoid walled gardens, rent seeking and the rise of systemic players that pose a financial stability risk.

In China, policymakers are striving to harvest the benefits of digitalisation by fostering an efficient digital payment ecosystem while at the same time managing the risks brewing in certain parts of the digital lending ecosystem, such as peer-to-peer lending. My understanding is that one of the aims of the recent reorganisation of financial regulators in China is to close regulatory gaps and improve coordination across policy authorities. China's experience can perhaps offer lessons for others regarding ways to manage risks arising from new financial business models.

Meanwhile, advances in financial technology are affecting the very nature of money. Blockchain technology in particular has given rise to alternative private money "candidates". These candidates are directly challenging the role of the central bank as an issuer of money. These candidates include native crypto tokens like Bitcoin and Ether as well as stablecoins that borrow their credibility from the regulated financial system. Some believe that these alternatives can serve as effective forms of money. It is true that these innovations have brought novel features such atomicity and programmability to prominence. Yet, they are inherently flawed, as much BIS work has shown.⁶  Flaws include volatile valuations, congestion, the false promise of decentralisation and violations of singleness. They also raise money laundering and illicit financing concerns.

There are several options for tackling the challenges that crypto assets pose to public money.⁷  Some jurisdictions prefer a ban, as is the case in China. A second option is to allow crypto but ringfence it. The Basel Committee for Banking Supervision has issued a standard that limits banks' exposure to crypto assets such as bitcoin. A third alternative is regulating crypto in a manner akin to traditional finance. For example, in Hong Kong, a stablecoin sandbox will enable the Hong Kong Monetary Authority to communicate supervisory expectations and guidance to institutions that plan to issue stablecoins. In Singapore, the Monetary Authority of Singapore has issued capital, liquidity and disclosure requirements for stablecoin issuers to ensure a stable value and redemptions at par.

In parallel, the traditional financial system must also evolve to meet the changing demands and expectations of users. A case in point is the rising demand for a tokenised form of money that can be used for "on-chain" purchases and sales of tokenised assets. Last year, in the BIS Annual Economic Report we conceptualised unified ledgers that strive to facilitate exactly that. Using a network of connected ledgers, unified ledgers bring together on a programmable platform tokenised central bank money in the form of a wholesale CBDC, tokenised commercial bank deposits and tokenised assets. In other words, unified ledgers capture the benefits of tokenisation in a safe, regulated and trusted manner. The eCNY initiative, I believe, shares this pursuit of embracing innovation in the regulated financial ecosystem. The exploration of novel features such as offline functionality is a public good that I am sure other economies would benefit from. Other central banks in the region, including the HKMA and Bank of Korea are also exploring the application of unified ledgers within the context of their own financial systems.

BIS and central bank cooperation

The BIS is helping central banks embrace such emerging changes in several ways.

One way is by providing a forum for discussion and cooperation. The various meetings we organise in collaboration with central banks help forge common knowledge and decide on common actions.

These meetings are coordinated at a global level in Basel and complemented by regional discussions through the BIS representative offices in Hong Kong and Mexico. The offices serve as centres for BIS activities in the Asia-Pacific region and the Americas, respectively. They address the needs of the central banks in those regions and anticipate changes affecting them. Our office in Hong Kong marked its 25th anniversary last year.

Some meetings, like those of the Basel Committee on Banking Supervision, often attract global attention. Others are lower key but no less vital. An example is the Central Bank Governance Group, where central banks exchange views on governance and organisational arrangements. Governors meet regularly to discuss issues such as central bank mandates, decision-making processes and corporate culture. At the working level, a network of experts facilitates the flow of practical information about the design and operation of central banks. This information not only provides input for Governors' discussions but also helps inform changes to central bank laws and institutional arrangements.

Another example of coordination is the Asian Consultative Council (ACC), which was set up in 2001 and includes the Governors of the 13 BIS member central banks from the region. The ACC has helped guide the BIS's work in Asia and the Pacific and convey the region's experiences and interests to the wider BIS membership.

The PBC is represented in many BIS meetings, including as a member of the BIS Board of Directors since 2006. We also regularly co-host events with the PBC. The success of the Green Swan Conference in 2022 was due in no small part to the PBC's contributions. The BIS and the PBC have also joined forces to co-chair a group from the Network for Greening the Financial System. Here in Beijing on Thursday and Friday, the group is meeting to share knowledge about the latest research on the economic and financial impact of climate change.

A second way that the BIS helps central banks to seize the opportunities offered by changes is by providing a platform for innovation and experimentation. The BIS Innovation Hub was launched in 2019 to create public goods that could serve not only central banks but also the wider financial system. In collaboration with many central banks, it has initiated experimental projects covering a wide range of topics.⁸ Many of the projects conducted in collaboration with regional central banks, including Project Nexus in our Singapore centre and Project m-Bridge in our Hong Kong centre, explore issues related to digital innovation in money and payments that I discussed previously.

A third way that the BIS supports central banks is via research and analysis on topics of relevance to central banks. The BIS was one of the early voices in the CBDC space, where we focused on its design considerations.⁹  Recently, we proposed the concept of the "Finternet" as a vision for the future financial system – multiple financial ecosystems interconnected with each other, much like the internet.¹⁰  Unified ledgers are a promising vehicle to turn this vision into reality. And in the coming months and years, artificial intelligence will be a focus area for us.

Even while stepping up our analysis of the digital revolution, the BIS has continued to shed light on the changes in the macroeconomic and financial environment. A chapter in last year's Annual Economic Report highlighted the need for monetary and fiscal policies to operate within a "region of stability", where constellations of these policies foster economic stability. BIS economists have also delved into the dynamics of inflation, including the important question of how relative price changes interact with generalised ones.

Finally, the BIS provides banking services that evolve as the needs of reserve managers change. For instance, the BIS has developed options to provide liquidity to central banks in times of market stress. It has also instituted an Asian green bond fund with a view to further deepen regional green bond markets.

Conclusion

Let me conclude with a Chinese proverb: when the winds of change blow, some people build walls and others build windmills. In the case of central banks, I think both strategies are required. Some changes, like the macroeconomic ones experienced recently, require central banks to pursue unswervingly their core role of maintaining the value of money: to reinforce the walls on which trust in money is built. Other changes, like the digital revolution, require central banks to think afresh about the potential opportunities: to build windmills that harness technology for improving the financial system.

¹        A Carstens, "Digital currencies and the soul of money", speech at Goethe University's Institute for Law and Finance on "Digitalization, the New Finance and Central Bank Digital Currencies: The Future of Banking and Money", 18 January 2022.

²        P Amatyakul, F De Fiore, M J Lombardi, B Mojon and D Rees, "The contribution of monetary policy to disinflation", BIS Bulletin, no 82, 20 December 2023.

³        BIS Asian Consultative Council (ACC), Inflation, external financial conditions and macro-financial stability frameworks in Asia-Pacific, report by a Working Group established by the ACC, 10 October 2023.

⁴        G Benigno, B Hofmann, G N Barrau and D Sandri, "Quo vadis, r*? The natural rate of interest after the pandemic", BIS Quarterly Review, March 2024, pp 17–30.

⁵        C Cantú, J Frost, T Goel and J Prenio, "From financial inclusion to financial health", BIS Bulletin, no 85, March 2024.

⁶        BIS, The crypto ecosystem: key elements and risks, report submitted to G20 Finance Ministers and Central Bank Governors, July 2023.

⁷        M Aquilina, J Frost and A Schrimpf, "Addressing the risks in crypto: laying out the options", BIS Bulletin, no 66, January 2023.

⁸        For information about the Innovation Hub projects, see www.bis.org/about/bisih/projects.htm.

⁹        S Chen, T Goel, H Qiu and I Shim, "CBDCs in emerging market economies", BIS Papers, no 123, April 2022.

¹⁰      A Carstens, "The Finternet: A giant leap for the financial system", speech at the Peterson Institute for International Economics event on "A vision of the future financial system", Washington, DC, 19 April 2024.