Relevance: GS- 3: Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment.

Key Phrases: Digital currency, Fiat currency, financial inclusion, Cryptocurrencies, Blockchain technology, Money laundering, Decentralised consensus approach, Monetary policy, Demonetisation, Formalisation, Informal economy.

Why in News?

• 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 introduction and evolution of cryptocurrency and blockchain technology have created further interest in cashless societies and digital currencies. Thus, governments and central banks worldwide are exploring the possibility of using government-backed digital currencies. But, before adopting CBDC, RBI needs to look at several considerations, including the underlying technological architecture and impact on cash circulation and banks, will determine how it is designed.

Considerable factors before issuing CBDC:

• Underlying technology architecture: Should the CBDC be based on the distributed ledger technology like Bitcoin?
  • Advantage: Bitcoin is a decentralised consensus approach. Every participant in Bitcoin’s decentralized system enjoys democratic control and financial sovereignty.
  • Disadvantage: 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.
• Will CBDC be account- or token-based?
  • At its core, an account-based framework, like bank deposits, links ownership with identity. It also potentially increases the risks for banks.
  • On the other hand, as some have said, a token-based framework, like cash, provides for greater anonymity. It raises concerns such as money laundering.
• What will determine the supply of CBDCs?
  • If CBDCs is issued 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.
• If RBI chooses to limit the supply –It will mean Capping the digital currency in circulation: To limit the amount that can be held by individuals and companies.
  • 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.
• Whether digital currency will be interest-bearing?
  • If yes, then the digital currency, without any caps, will emerge as a perfect substitute for bank deposits.
  • But Banks will then face the threat of deposits shifting to the CBDC, and losing out on their source of funding. They may respond by raising funds at higher costs, which will impact their margin or lending rates, thus affecting credit demand.
  • Also, CBDCs can help improve the efficacy of monetary policy by reducing the problems associated with the “pass through” of rates through banking channels.
  • CBDC vs usage of cash: 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 the large informal economy, especially the agricultural sector
  • 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.
• To what extent the much-touted benefits of issuing CBDCs will materialise in India.
  • 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.

Conclusion:

• Countries like Ecuador, Tunisia and Scandinavian countries have launched digital currency in pilot mode and many central banks have pilot programs and research projects intending to determine the viability and usability of a CBDC in their economy. There were nine countries as of February 2022 which have launched 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.

Sources: Investopedia , Indian Express

Mains Question:

Q. What is the central bank digital currency (CBDC). Determine the feasibility of CBDC in India and what factors to consider before its issuance. Critically Analyse. [250 words]