The e-rupee will yield demand-side learnings

RBI has chosen two very different designs for the two variants of the new digital rupee. Photo: iStock
RBI has chosen two very different designs for the two variants of the new digital rupee. Photo: iStock


The current design of India’s CBDC is appropriately conservative but the idea has plenty of potential that could be explored.

Money issued by central banks has changed form over modern history—from coins made with precious metals to paper money that could be converted on demand into gold, to inconvertible fiat money that is only backed by the word of a sovereign government. The fourth big transformation is upon us. Central banks across the world have begun experimenting with various forms of digital money. India has also taken its first tentative step. The Reserve Bank of India (RBI) has launched two variants of a digital rupee on an experimental basis—for wholesale transactions between banks and for retail transactions within the private sector.

A lot of the global discussion of digital currencies has been around the supply side, especially how central banks should design this new form of money. Less attention is paid to the demand side, even though traditional monetary economics itself gives equal weight to both. There are lessons from recent history. For example, central banks were forced to abandon money-supply targeting as the intermediate goal of monetary policy because demand for money became unstable after the 1980s, as household and firms got a greater choice of financial instruments to hold. They shifted to interest rate targets. More recently, the value of Bitcoin swung wildly not because of instability of supply, but sudden changes in demand from users. Bitcoin was supposed to guarantee monetary stability by managing money supply through an algorithm rather than human agency; the demand side was given inadequate attention.

Shifts in how the world plays
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Shifts in how the world plays

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RBI has chosen two very different designs for the two variants of the new digital rupee. The wholesale variant operates through the accounts that commercial banks have with the Indian central bank. The retail variant is based on a two-tier system—individuals and firms can hold it only through the banking system. It is thus based on the idea of tokens. RBI will issue the digital rupee but banks will distribute it to the private sector.

What this means is that the first experiments with central bank digital currencies (CBDCs) in India do not try to alter the current monetary system, in which only banks have accounts with RBI while the rest of the economy operates through the commercial banking system. Economist James Tobin proposed in 1985 that households should be allowed to have direct accounts with the US central bank. The radical innovation of allowing citizens to have direct accounts with the Indian central bank has been put off for now, and rightly so.

The digital rupee does not pay any interest to its holder. It is thus a substitute for cash rather than a substitute for bank deposits. Why? Cash is also a liability of the central bank that is issued at zero interest rate. An interest-paying CBDC held directly with RBI would give bank deposits a run for their money, creating financial stability risks. It will also complicate the conduct of monetary policy, especially when households move money between their accounts with commercial banks and the central bank, leading to fluctuations in the monetary base. However, there is no doubt that the truly radical possibilities of a CBDC will be tested when citizens bank directly with the central bank.

Now comes the question of demand, especially for the retail version of the digital rupee. In the quarter ended March 2022, Indian households held 28.83 trillion of cash as compared to 115.71 trillion of bank deposits. A recent research paper by economists at the International Monetary Fund shows that the use of cash as a mode of payment has actually grown in India between 2005 and 2020 (though the past three years have seen a decline in this share) . The use of instant payment options such as NEFT and IMPS has shot up. The use of cheques and demand drafts has dropped sharply (see chart for international comparisons). The Indian government is keen to reduce the use of cash in the economy. Will the digital rupee help?

The current design of the Indian CBDC is focused on money as a medium of exchange rather than a store of value. India already has a world-class digital payments system, or the United Payments Interface (UPI). It has become ubiquitous in most parts of the country. The current version of the retail CBDC—admittedly an initial experiment to feel the waters—has to compete with the UPI ecosystem. It will be worth seeing how that works out in the coming months.

In the early years of the 20th century, a group of monetary theorists known as chartalists argued that modern money has no intrinsic value but is widely accepted in a territory because the government requires that you pay taxes in that money. Even earlier, during another era of monetary innovation, a wise man said: “A prince, who should enact that a certain proportion of his taxes be paid in a paper money of a certain kind, might thereby give a certain value to this paper money". That was Adam Smith in his classic book, An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776.

Does that idea deserve a fresh airing in this new age of CBDCs?

Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics.

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