Inflation, Blockchain and Stablecoins - A Case Study on Latin America

As we look at how blockchain might start to impact day-to-day payments, lending, and investing, we review some of the policies and mechanisms which central banks and governments use in order to manage money supply and inflation. We then review how these policies are being impacted by blockchain and crypto.  We consider how high inflation economies can benefit from the use of stablecoins without giving up full control of monetary policy.  Lastly, we review some of the different options being considered for either the issuance of central bank issued digital currencies or for countries to adopt bitcoin or another crypto coin as legal tender. 

The Background of Blockchain

Although the concept of digital currencies and blockchain is still reasonably new, when utilized correctly, it is clear that blockchain will have a significant impact in how we pay, borrow and invest. This will invariably offer new tools as well as challenges to central banks and governments. 

Blockchain technology has been around since 1991, but the white paper describing the decentralized process of transacting bitcoin popularized the concept in 2008 .  In simple terms, a blockchain is a shared database filled with entries that must be confirmed by peer-to-peer networks and encrypted.  As interest in crypto currencies has grown, the uses for blockchain based services has exploded, with global spending on blockchain expected to reach $17.9 Billion by 2024 (according to Business Insider).  We will look at some of the ways that individuals and governments plan to use blockchain technology and how high inflation countries could see the use of blockchain technology impact how consumers save and spend. 

When we look at economic cycles and how governments and central banks look to manage growth and inflation, there are a number of theories. One concept that economics tend to agree on, however, is that inflation, when not contained, can severely impact both growth and confidence in the economy.  Inflation can be a feature of economic recovery but can also be driven by low rates, external trade shocks and government spending.  Milton Friedman, the famous economist, wrote that inflation is taxation without representation.   Friedman, like many of those in the monetarist theory of economics, consider inflation as a real tax and nearly as important as the individual income tax. Additionally, while inflation reduces the purchasing power of your earnings, it also redistributes purchasing power from businesses and households to the federal government. 

Historically, countries that have run large fiscal deficits often find themselves printing money in order fund their deficit, resulting in a depreciating currency.  In the case of Argentina, inflation has been hovering around 50% per year for the past few years, while the official USD/ARS exchange rate has gone from 38 Pesos per USD in 2019 to 111 Pesos per USD in 2022 (the “unofficial rate” is now 200 Pesos per USD).  In the case of Latin America, the countries which experience exchange rate instability tend to find themselves in some form of dollarization where exports simply price their goods in USD and, in many cases, may get paid offshore in USD.  Governments can have difficulty in managing their balance of goods in these situations, leading them to push higher rates to attract more capital or using regulation to restrict capital flows.

Source: The World Bank

Central Bank Issued Digital Currencies and Legal Tenders

In the past few years, we have seen a new tool that can be used by both individuals as well as governments – blockchain.  In recent years, we have seen three central bank digital currencies launched, with another 15 currently running in a test phase.  Central Bank issued Digital Currencies (CBDC) are effectively a digital version of the fiat currency.  CBDC has a number of advantages that offer consumers a digital way of holding and spending money.  In the case of China, there have been efforts to use the CBDC to send money to specific regions or groups as part of the Central Bank’s monetary policy toolbox.  In addition, the central bank or government can restrict the ways the money can be spent or require that it be spent within a specific time frame.  One of the concerns that citizens have about digital currency is that it does allow the government to see how individuals spend and who they pay and are paid by.  Issues around privacy are likely to be an area of concern for many consumers to take up CBDC without assurances that safeguards protecting privacy will be in place. 

An alternative to a CBDC is a ‘stable coin,’ which can be issued by a private company or a Digital Autonomous Organization (DAO).  These coins operate as a digital version of the fiat currency but the central bank and government do not issue these currencies.  Some stable coins are 100% backed by fiat currency and others are dynamically managed by their issuer.  A common use case for stablecoins is to act as collateral for crypto investors who wish to hold a USD based asset but in crypto format. 

Another alternative is for a country to make a crypto currency legal tender. This was recently implemented by El Salvador.  In September of 2021, El Salvador’s President Nayib Bukele declared that Bitcoin can be used to make payments for both paying government fees and taxes as well as for personal and business expenses, making it the first country in the world to make Bitcoin legal tender.  The reasoning for this was driven by the high dependence of the country on remittance income as well as the fact that 70% of the population of El Salvador is unbanked.  Although the rollout has not been without issues, over 2.1 Mio of the population have used bitcoin to make or receive payments, which is slightly more people than the population of El Salvadorians that have bank accounts.  There are plenty of arguments for and against using bitcoin as legal tender, but when we look at ways of facilitating payments, the additional volatility of holding a crypto-currency like bitcoin creates risks that many small businesses and consumers are not prepared to accept. 

Source: The Global Economy

When looking at developing economies and how policy makers attract inward investment, there has always been a tradeoff between exchange rate flexibility, independent monetary policy and free capital movement.  There has been much research in this area and led to the Mundell–Fleming economic model which suggests that developing economies must sacrifice one of these components in order for the other two to exist.  An interesting case study on this concept is the country of Argentina which implemented a one-to-one exchange rate with the USD in order to address the hyperinflation the country had experienced in the 1980’s.  In April of 1991, the recently elected President Menem implemented a peg for the Argentine currency which brought down inflation from upwards of 1,000% to a mere 1%, and which then averaged around 4% for the remainder of the decade.  Although the peg was effective in creating confidence in the exchange rate, it meant that interest policy for Argentina was not decided by its central bank but rather the US Fed.  As Argentina fell into a recession in the late 90’s, the county was forced to abandon the peg leading to a collapse in the economy.  The government restricted bank withdrawals leading to social unrest and limited confidence in the banking system.  Today, roughly 52% of Argentinians are unbanked and for many, the concern that the government can seize or limit withdrawals looms large. 

Blockchain As a Solution

We believe that blockchain can offer developing economies such as Argentina a new way to access banking and payment services. The ability to hold money on a phone or computer, to send or receive payments, and to hold stablecoins will open a new chapter for developing economies.  It will offer consumers and businesses significantly more flexibility and choice when dealing with a high inflation economy.    Additionally, for countries which regulate foreign currency holdings and flows, this presents new challenges.  It will likely take time for the regulations to catch up with the crypto offerings. 

If consumers were to shift to digital stable coins held in their crypto wallet, this would have a number of benefits.  Consumers holding digital USD should be safer than holding cash in a safe (or under their mattress).  Using the appropriate computer security and secure password storage, consumers should be able to efficiently move money into digital USD and back to their local currency in a much more efficient way than moving physical USD in and out of local currency. 

If consumers chose to hold their surplus savings in a digital USD, it would also allow these savings to be invested offering additional return for the consumer.  As the stable coin investment market evolves, consumers can select from secure investments to more speculative, allowing their investment to appreciate and be part of their investment portfolio.  For many who are unbanked, holding a digital wallet for savings, investment and potentially borrowing allows a greater portion of society to achieve financial independence. 

Looking at a digital USD and ways that businesses could choose to accept either local currency or USD, a business could offer customers the choice of paying in local currency or in USD.  The business could also choose to hold the payment in either USD or local currency, making the process simple and efficient. 

In the case of El Salvador, the country’s mobile cellular subscription rate per 100 is at 161, meaning in a country of roughly 6.1 million people, there are roughly 8.9 million mobile connections (according to The World Bank data). Feasibly, digital currency is easily accessible to most people.

In the case of Argentina, one of the major challenges of countries is the amount of business that is done in USD and in cash, meaning that much of this revenue is not taxed nor counted as part of the economy.  Therefore, allowing companies to receive both USD and local currency would create a more efficient paper trail, and in many cases, would make it easier for the government to get a more accurate understanding of economic growth as well as increase tax revenue. 

In this paper, we highlight a use case scenario of how the blockchain can be utilized by developing economies to offer businesses and consumers more access to financial services, a greater ability to hold money in the form of a stablecoin to minimize inflation impacts on financial holdings, and the ability to harness digital holdings creating additional investment in the local economy.  In addition, we believe offering businesses and consumers the capability to transact in digital currencies will offer central banks and local economies more transparency on local economy growth, and if implemented correctly, greater investment in the local economy as money is moved out of cash holdings and into local investment.