In the Union budget presented a few weeks ago, Finance Minister Nirmala Sitharaman proposed to introduce a digital currency in the coming financial year. While the RBI is still in the process of figuring out the contours of what a digital rupee will look like — it is expected to carry out pilot studies in this area shortly — there are several design/conceptual issues that it will need to examine. How the RBI views each of these features will determine the form, functionality and ultimately the utility of the digital rupee.
The first consideration centres around the underlying technology architecture — should the CBDC (central bank digital currency) be based on the distributed ledger technology à la Bitcoin? While there are inherent advantages to a decentralised consensus approach, some argue that this architecture is “slow and inefficient” compared to centralised ledger systems. The time it takes to validate and settle transactions is high, and the number of transactions that can be handled by the network is low. For instance, it takes 10 minutes on average to settle a bitcoin transaction. Thus, there are issues of scalability with this framework.
Second, will the digital currency be account- or token-based? At its core, an account-based framework, like bank deposits, links ownership with identity. On the other hand, as some have said, a token-based framework, like cash, provides for greater anonymity. While the former could potentially increase the risks for banks, the latter raises concerns such as money laundering.
Third, what will determine the supply of CBDCs? If the central bank decides to issue CBDCs over and above the incremental physical currency that it prints and injects every year into the economy, it will lead to a significant expansion of its balance sheet. The RBI will then have to purchase an additional equivalent amount of government debt or any other securities. This will raise troubling questions on how the central bank allocates its investment portfolio. However, the RBI can choose to limit the supply of digital currency by substituting it for some part of the incremental physical currency it injects each year.
Fourth, accepting the latter option may effectively result in capping the digital currency in circulation, and thus the amount that can be held by individuals and companies. This will, in turn, limit its usage, at least in the initial years. Imposing limits or capping the amount that can be held as CBDC will also reduce the risk of deposits shifting away from commercial banks, thus allaying fears that during times of financial distress, depositors will move from bank deposits to CBDCs and aggravate the crisis.
Fifth, the central bank will also have to decide if the digital currency will be interest-bearing. This, along with the quantum of CBDCs in circulation, will have a bearing on the financial system and monetary policy.
If the RBI opts for the interest-bearing option, then the digital currency, without any caps, will emerge as a perfect substitute for bank deposits. Banks will then face the threat of deposits shifting to the CBDC, and losing out on their source of funding. As some have argued, they may respond by raising funds at higher costs, which will impact their margin or lending rates, thus affecting credit demand. Considering these implications, the RBI may have to explore the possibility of putting in place a permanent “window” for banks, to help offset any asset-liability mismatches that may arise.
On the flip-side, though, an interest-bearing CBDC, without any caps, can also morph into an instrument for monetary policy. CBDCs can help improve the efficacy of monetary policy by reducing the problems associated with the “pass through” of rates through banking channels. However as some have pointed out, the notion that CBDCs will help central banks face the zero lower bound does not really apply in developing economies like India which, at least for now, do not face a similar constraint.
Sixth, there is also the usage of cash to contend with. Unlike the economies of the US and Sweden, the Indian economy is still characterised by the widespread use of cash. In fact, as a percentage of the GDP, currency in circulation is higher now than before demonetisation, despite a surge in digital transactions during this period.
Limiting the physical currency in circulation may in fact have an adverse effect on parts of the economy that are predominantly dependent on cash as a medium of exchange. The large informal economy, especially the agricultural sector, comes to mind. While this fits in with this government’s desire for greater formalisation, forced formalisation will render many informal units uncompetitive and could cause disruption in agriculture.
Lastly, in its pilot studies, the central bank should also explore to what extent the much-touted benefits of issuing CBDCs will materialise in India. There is reason to be sceptical as India already has a robust payments infrastructure in place. The domestic payments ecosystem is characterised by low transaction costs and quick turnaround time. And, unlike China, there is healthy market competition. So to what extent the introduction of a CBDC will aid in further accelerating financial inclusion, facilitating low-cost transactions for low-income households, is debatable.
Some have also argued that as a CBDC is a liability of the central bank and not commercial banks, it will minimise the depositors’ exposure to their bank. But this argument fails to account for the presence of public sector banks — it is difficult to imagine a scenario where the Union government or the regulator allows a public sector bank to fail or depositors not to be paid in full due to political considerations. Moreover, this argument also assumes the absence of any limits on the issuance and holding of CBDCs.
Perhaps in formulating its views on digital currencies, the RBI should simply be guided by the desire to preserve its monetary sovereignty. Either way, it should tread carefully.
This column first appeared in the print edition on. February 18, 2022 under the title ‘Checklist for digital currency. Write to the author at firstname.lastname@example.org.