In late October, Nigeria launched its non-interest-yielding central bank digital currency (CBDC) — the eNaira. In doing so, it joined the Bahamas and five islands in the East Caribbean as the only economies to have introduced CBDCs. This is a short list, but one that is likely to be supplemented. CBDC pilot projects are underway in at least 17 other countries.
In substance, the great hope for the eNaira lies in its perceived potential to address inefficiencies in Nigeria’s payment, remittances, and public welfare distribution systems, while progressing financial inclusion. The eNaira enables targeted welfare payments into the wallets of citizens directly, eliminating the need for intermediaries. In parallel, the Central Bank of Nigeria claims that the eNaira will offer secure and cost-effective channels for in-bound remittances — a key source of foreign exchange for the country. The eNaira is also attributed with progressing financial inclusion because it has been designed as an account-based CBDC with know your customer (KYC) norms linked to the unique identity indicators under Nigeria’s National Financial Inclusion Strategy.
This desire to make domestic payments systems and cross-border remittances cheaper, faster and more efficient, and deepen financial inclusion, represent key areas of priority for most other emerging market and development economies (EMDEs). In fact, between 2019 and 2021, the last three surveys conducted by the Bank for International Settlements showed that the primary drivers for central banks of EMDEs to study CBDCs were domestic payments efficiency, financial inclusion and payments safety.
So, how could CBDCs solve all of these long-standing issues? And are CBDCs the most elegant solution for such problems? In short, it depends. In theory, the potential of CBDCs are only limited by their design and the capabilities of the central bank issuing it, but their appropriateness and form also depend on the state of the domestic banking and payments industry. Ultimately, CBDCs must be seen as a means to an end. A particular CBDC could, for example, be account-based or tokenised, may be distributed directly by the central bank or through intermediaries, may be interest-bearing (even the possibility of a negative interest has been considered), may be programmable, may offer limited pseudonymity to its holders (similar to, but not to the extent of, cash) and so on. Whether it may be one or the other depends on what its country requires it to be.
The first-order challenge, therefore, for any central bank considering CBDCs lies in matching their domestic priorities with design features. Given that a CBDC could substitute or complement cash and private e-money, there are also significant domestic economic consequences that will follow the design elements, particularly the potential of CBDCs to be interest-bearing. An economy that adopts an interest-bearing CBDC could make the interest rate on CBDCs the main tool of monetary policy transmission domestically (assuming a high degree of substitution of fiat and fiat-like currency). In such a case, monetary policy transmission would no longer be constrained by the downward rigidity of interest rates and traditional limitations of zero-lower bound.
On the other hand, as former RBI Governor D Subbarao recently warned, rendering an Indian CBDC as an interest-bearing instrument could pose an existential threat to the banking system by eroding its critical role as intermediaries in the economy. If CBDCs compete with bank deposits and facilitate a reduction of bank-held deposits, banks stand to lose out on an important and stable source of funding. Banks may respond by increasing deposit rates, but this would necessitate a higher lending rate to preserve margins, and dampen lending activities. At the same time, banks may be perversely incentivised to engage in riskier lending and hold relatively risker, less-liquid assets.
The resultant shrinking of balance sheets will lead to a more pronounced disintermediation role for financial institutions, which could have long-term effects on financial stability, and facilitate easier bank runs. The introduction of CBDCs would require central banks to maintain much larger balance sheets, even in non-crisis times. They would need to replace the lost funding (because of migration of deposits) by lending potentially huge sums to financial institutions, while purchasing correspondingly huge amounts of government and possibly private securities. CBDCs could also have implications for the state from seigniorage as the cost of printing, storing, transporting and distributing currency can be reduced.
Recent comments by RBI officials have focussed on the desirability of introducing CBDCs. But the path to a “Digital Rupee” is not clear.
This column first appeared in the print edition on November 16, 2021 under the title ‘Path to the digital rupee’. The authors are respectively, Senior Fellow and Research Fellow at NIPFP. Views are personal