In the Union Budget 2022, Finance Minister Nirmala Sitharaman announced that the Reserve Bank of India (RBI) will introduce a ‘Digital Rupee’ in fiscal 2022-23. This will be done using blockchain and other technologies. The FM highlighted the fact that the Central Bank Digital Currency (CBDC) will give a big boost to digital economy within the country. Digital currency will also lead to a more efficient and cheaper currency management system. It can also help reduce the menace of black money.
The origin of CBDCs can be traced back to the 1980s when Nobel laureate James Tobin, an American economist, recommended that the United States Federal Reserve Banks could bring the availability of a widely accessible medium with the convenience of deposits and the safety of currency to the public. Notably, it is only in the last decade, that the concept of digital currency has taken centre stage in conversations between central banks, economists and governments around the world.
Earlier, in a research paper, RBI’s deputy governor T Rabi Sankar explained that except as currency notes, all other use of paper in the modern financial system, be it as bonds, securities, transactions, communications, correspondences or messaging – has now been replaced by their corresponding digital and electronic versions. The use of physical cash in transactions has been on the decline in recent years, a trend further reinforced by the coronavirus pandemic. These developments have resulted in many central banks and governments stepping up efforts towards exploring a digital version of the currency. Some of this interest has been indigenous for pursuing specific policy objectives – for example, facilitating negative interest rate monetary policy. Another driver is to provide the public with virtual currencies, that carry the legitimate benefits of private virtual currencies while avoiding their damaging social and economic consequences.
Just like a normal term of currency, digital currency also referred to as fiat currency is issued by the central bank. Hence, the word ‘Central Bank Digital Currency’. It is a legal tender in a digital form and will be exchangeable one-to-one, however, the form of exchange will be different.
As the name suggests, CBDC is a digital or virtual currency but it would not be right to compare it with the private virtual currencies which have mushroomed over the last decade.
T Rabi Sankar's research paper explains that private virtual currencies sit at substantial odds with the historical concept of money. They are not commodities or claims on commodities as they have no intrinsic value; some claims that they are akin to gold seem opportunistic. Most popular virtual currencies do not represent any person’s debt or liability. There is no ISSUER. They are not money (certainly not CURRENCY) as the word has come to be understood historically.
That said, CBDC is defined as similar to the normal currency issued by the central bank but in a different form other than paper or polymer.
The digital currency will be a sovereign currency introduced in an electronic form and would appear as a liability just like the currency in circulation, on a central bank’s balance sheet. The catch would be the underlying technology, form and use of a CBDC which the central bank will mould for specific requirements. To sum up, CBDCs can be exchangeable at par with cash.
A 2021 BIS survey of central banks revealed that 86% were actively researching the potential for CBDCs, 60% were experimenting with the technology and 14% were deploying pilot projects.
Why Digital Currency?
One of the common reasons why a country will opt for digital currency will be the fact, that polymer or paper currencies are seen as a liability for the central bank's balance. There are hosts of costs and charges required for printing a currency and that takes a chunk of the central bank's financial books. In the case of RBI, it pays a dividend to the government every year from its profit. With digital currency in circulation, RBI's expense will decline and result in higher profit and will add to the government's accounts.
Secondly, the central banks are facing dwindling usage of paper currency and hence they seek to popularize a more acceptable electronic form of currency.
With digital currency, the situation of damaged currencies which are usually the case with many papers or polymer currencies will be reduced.
Central banks seek to meet the public’s need for digital currencies, manifested in the increasing use of private virtual currencies, and thereby avoid the more damaging consequences of such private currencies.
Furthermore, the advent of private virtual currencies is another reason driving the need for CBDCs. For a government, having its own CBDC could support and enable the public with uses that any private virtual currency can provide and that can bolster public preference for the Indian National Rupee.
Advantages of Digital Currency
CBDCs have a vast range of advantages over other digital payments systems. For instance, payments that are done using CBDCs will be final and thus reduce settlement risk in the financial system. CBDCs will boost the digital economy as they are only accessible via electronic devices. CBDCs in general terms do not need intermediaries and are typically the cheapest method for trading in currencies. Transactions using CBDCs will be feasible, flexible and cheaper.
Currently, India is among the leading economies for digital payment innovations. Digital payment systems are available 24X7 for both retail and wholesale customers. Not just that, digital payments are also largely real-time, cheaper in comparison to many other countries and users have an impressive menu of options for doing transactions. Over the last five years, digital payments have grown at an impressive CAGR of 55%. This does show that India is ready to adopt a 'Digital Rupee'.
A pilot survey conducted by the RBI on retail payment habits of individuals in six cities between December 2018 and January 2019, results of which were published in April 2021 indicated that cash remains the preferred mode of payment and for receiving money for regular expenses. For small value transactions (with amounts up to Rs500) cash is used predominantly. Thus, as per RBI, there is a case of the increasing proliferation of digital payments in the country coupled with a sustained interest in cash usage, especially for small value transactions. To the extent the preference for cash represents a discomfort for digital modes of payment, CBDC is unlikely to replace such cash usage. But the preference for cash for its anonymity, for instance, can be redirected to acceptance of CBDC, as long as anonymity is assured.
Disadvantages of Digital Currency
There are certain risks and disadvantages of having digital currencies. For instance, CBDCs can reduce the transaction demand for bank deposits since the digital currencies have the potential to reduce settlement risk and thus they reduce the liquidity needs for settlement of transactions (such as intra-day liquidity). Thereby, even though CBDCs are genuinely risk-free alternatives to bank deposits, they could lead to a shift in bank deposits transactions, impacting the need for government guarantees on deposits.
Similarly, reduction in the disintermediation of banks has its risks. For example, if CBDCs take a toll on bank deposits in the future course, that would also dampen their credit creation ability as it will get constrained. Deposits are a liability for banks but a source of liquidity as well, while loans are assets for these banks and a source of income through interests. With a drop in bank deposits transaction, banks may also see stress in their interest margin which may lead to an increase in the cost of credit.
However, the impact of CBDCs can be limited as in the digital currency there is no need of paying interest and banks do pay a percentage for the sum that is deposited by the customers. CBDC will bring a change in the behaviour of the holding public which needs to be monitored.
Overall, digital currencies are the new era for a cashless economy. RBI will have to take into account a host of risk factors before finally releasing the 'Digital Rupee' in the country.