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Why the Reserve Bank wants to have its own digital currency

CBDC is different from cryptocurrency. It is issued by a central bank and is backed by the sovereign like fiat money is. Some advantages of CBDCs include greater financial inclusion and a boost to the war on black money and corruption (Photo: Mint)Premium
CBDC is different from cryptocurrency. It is issued by a central bank and is backed by the sovereign like fiat money is. Some advantages of CBDCs include greater financial inclusion and a boost to the war on black money and corruption (Photo: Mint)

  • India’s payments space is not yet a realm of monopolies. But a digital rupee makes sense for other reasons
  • If CBDCs do work in the long-term, it would mean the end of cash as we know it and use it now. While that does solve some problems, it will also create others

The Cryptocurrency and Official Digital Currency Bill, 2021, is scheduled to be introduced in the ongoing winter session of Parliament. Further, as per an answer to a recent question in the Lok Sabha, the government received a proposal from the Reserve Bank of India (RBI) in October to amend the RBI Act, 1934, in order to enhance the scope of the definition of a ‘bank note’ and include currency in digital form.

Clearly, the Indian government and the RBI are getting ready to launch a central bank digital currency (CBDC). A survey carried out by the Bank for International Settlements earlier this year found that 60% of the world’s central banks are experimenting with CBDC technology and 14% had started pilot projects.

Given this, it is important to understand what a CBDC really is and what it isn’t; what it hopes to achieve; the opportunities the shift is likely to throw up and the problems that it is likely to solve.

What is a CBDC?

In a speech in July, T. Rabi Shankar, a deputy governor of the RBI, defined a CBDC as a “legal tender issued by a central bank in a digital form," which “is the same as fiat currency and is exchangeable one-to-one with the fiat currency".

The Bank of England, the United Kingdom’s central bank, defines CBDC as “an electronic form of central bank money that could be used by households and businesses to make payments and store value".

Now, what does this mean in simple English? There are two kinds of central bank money—one made of paper/polymer notes (physical cash) that we use in our daily lives and the other is the reserves maintained by commercial banks with the central bank. These reserves are in a digital form and are used by banks to manage interbank payments. The banks can also exchange these reserves for cash at the central bank.

In that sense, at the wholesale level, there isn’t much of a difference given that money, in this segment, is already digital. As Eswar S. Prasad writes in The Future of Money—How the Digital Revolution is Transforming Currencies and Finance: “The new technology does not fundamentally change the nature of the asset, as it is already digital, but enables banks to use it more efficiently and cheaply."

If experts are to be believed, the retail segment—where a significant chunk of money is still in cash—is the real ground for near-term innovation. Retail CBDCs will essentially be digital currency issued by the central bank which will exist alongside physical cash. A Bank of England discussion paper says that the retail CBDC would be “denominated in pounds sterling, just like banknotes."

This digital currency would need an entirely new ecosystem, with the central bank—the RBI in the Indian case—managing the centralized payment system. This centralised payment system, as Prasad writes, would be “linked to electronic ‘wallets’ that reside on prepaid cards, smartphones, or other electronic devices". Of course, the money in these digital wallets can be spent in the same way as physical cash.

This system sounds very similar to individuals using payment apps that are already in place in India and all across the world. How is CBDC different then? For one, the payment infrastructure is created and managed by the central bank. Two, payments are made using central bank money and not the money created by the banking system.

But why do we need a central bank issued CBDC, especially given how the market is already saturated with fintech innovations? Let’s try understanding this through the examples of Sweden and China. Data from Riksbank, the Swedish central bank, shows that between 2010 and 2020, the percentage of people who paid in cash for their last purchase has decreased from 39% to 9%. Also, a bulk of this new digital payment infrastructure is managed by a few private companies.

China has gone the same way. As D Priyadarshini and Sabyasachi Kar point out in a working paper titled Central Bank Digital Currency: Critical Issues and the Indian Perspective: “China, for example, has seen near universal adoption of digital payments, with nearly 94% of mobile transactions supported by Tencent or Alibaba. Both entities have also combined several other financial services with their social media apps."

This kind of integration increases the overall risk in the financial system, with the entire digital payment infrastructure being dependent on a few private companies. As Priyadarshini and Kar write, this poses risks “of monopolies, high entry barriers, potential misuse of data, safety and security of technology".

Thus, there is a need for central banks to create a new digital payment infrastructure through CBDCs. The Riksbank, which has been experimenting with the e-krona, states that “in the event of serious shocks to the systems of the banks or card companies, an e-krona could be an alternative form of payment". Other than this, in China, the Chinese Communist Party is also compelled to put breaks on the proliferating clout of the private sector.

The Indian context

In India, the Unified Payments Interface (UPI) has been very successful in the digital payments space. It’s run by the National Payments Corporation of India (NPCI), an umbrella organization for operating retail payments and settlement systems, which is an initiative of the RBI and Indian Banks’ Association (IBA).

The NPCI is majorly owned by public sector banks but, given that it was formed on the initiative of RBI, it is safe to say that the government has some control over it. Also, the stake of each individual private company in NPCI is limited to a few percentage points.

UPI has proved to be a gamechanger in the digital payments space. Money can now be instantly transferred between two bank accounts using a mobile phone. In October, 4.21 billion transactions happened through it.

In that sense, the presence of UPI has ensured that India won’t go the Chinese or the Swedish way, where a few private firms might monopolise the digital payment system.

But despite this advantage, there are two reasons why India may still push ahead to create a well-functioning CBDC system. One is the complicated cross-border payments system as it prevails. As Prasad writes: “They involve multiple currencies, must often be routed through several institutions, and need to be consistent with country-specific financial regulations. The net result of such impediments is that cross-border payments have often been slow, expensive, and difficult to track."

A CBDC could handle these issues well. As RBI’s Shankar puts it: “It is conceivable for an Indian importer to pay its American exporter on a real time basis in digital dollars without the need of an intermediary. This transaction would be final, as if cash dollars are handed over." Of course, for this to happen, India needs to have a sovereign-backed CBDC that “will be trusted in a global system".

The other reason lies in the fact that China is betting big on its CBDC. In fact, China wants the digital yuan to play the same role in the international economy that the US dollar does today. Hence, and as Priyadarshini and Kar put it, “once the digital Yuan gains acceptability as a global currency, it is a matter of time before these will start flowing into the Indian economy".

Given the contentious relationship India shares with China, it needs to work towards limiting this possibility, which will be possible only through the development of global protocols for the cross-border usage of CBDCs and “in order to have a say in the development of these international standards… it will be very useful for India to have a credible and working CBDC".

More use cases

After the spread of the covid-19 pandemic, Western governments spent a lot of money to kickstart their domestic economies. This included directly depositing money into individual bank accounts. But the governments did not have the bank account information of all citizens. Hence, they also sent out cheques and debit cards loaded with money.

As Prasad writes about the American case: “Cheques and debit cards mailed… were delayed or lost. Scammers found ways to intercept some payments, while many recipients threw out (the) debit cards, mistaking them for junk mail." If a CBDC system was in place, the governments could have directly put money into the wallets of people. In fact, in order to get people to spend that money immediately, they could have deemed it to be expirable within a certain period.

On the flip side, this would mean that the fiscal policy and the monetary policy would get mixed up even further, blurring the line between the independence of a central bank and the government.

The other advantages of CBDCs include no counterfeiting of currency (until innovators figure out how to do that digitally), greater financial inclusion and a boost to the war on black money and corruption.

Introducing negative interest rates is another possibility that might emerge with a wider adoption of CBDCs. The only reason most central banks can’t implement negative interest rates is because people can simply withdraw their money from banks and other financial institutions and hold it in the form of cash.

But in a world of 100% digital money, negative interest rates are possible. This has got central bankers excited. In tough economic times, a central bank could mandate a negative interest rate on CBDCs stored in wallets, encouraging people to spend. Of course, people might still not spend, but a negative interest rate is an idea that central banks can resort to when they have run out of all other ideas.

In order to do this, CBDC will need to have the functionality of a savings bank account, where the central bank pays a certain amount of interest to depositors for keeping their money in the wallets. Only when you pay an interest can you charge a negative interest. As Shankar said in his speech: “Such steps may need to be taken with care as any instrument that pays interest (positive or negative) is strictly not a currency."

CBDCs and bank runs

A bank run is basically a situation where many depositors want to withdraw money from a bank if they perceive it to be fragile. In fact, this could be an unintended consequence of CBDCs.

As the Report on Currency and Finance 2020-21 points out: “CBDC… poses a risk of disintermediation of the banking system, more so if the commercial banking system is perceived to be fragile." People can move money from their commercial bank accounts to their CBDC accounts if they perceive a bank to be in trouble or if there is macro financial instability.

Hence, the design of the CBDC becomes very important. As the Bank of England discussion paper puts it: “Limits on individual holdings of CBDC could help ensure that CBDC is used primarily for payments and not for large savings, reducing the extent of disintermediation of the banking system."

Also, it’s only fair that a central bank, an institution which regulates the commercial banks, shouldn’t be directly competing with them. Hence, it is important that the RBI follows the two-tiered approach to CBDCs, where the central bank “creates the digital version of its currency", nonetheless, it “leaves the distribution of that currency and the maintenance of CBDC wallets to existing financial intermediaries". In fact, this is precisely how the Chinese CBDC is being developed.

Finally, there are two points worth taking into account. One, CBDCs are different from cryptos. While the original idea behind bitcoin, the first cryptocurrency, was to challenge fiat money and emerge as a medium of exchange, that hasn’t happened. Meanwhile, cryptos have become an object of speculation. Hence, as Shankar puts it: “They are not money (certainly not currency) as the word has come to be understood historically". CBDC, however, is money as it is historically understood. It is issued by a central bank and it is backed by the sovereign, like fiat money is.

Two, if CBDCs do work in the long-term, it would mean the end of cash. While that does solve some problems, it will also create others.

(Vivek Kaul is the author of Bad Money.)

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