The Reserve Bank of India has recently launched two pilot versions of Central Bank Digital Currencies (CBDCs)—the Digital Rupee-Wholesale (e₹-W) and the Digital Rupee-Retail (e₹-R). These digital currencies are virtual money backed and issued by the central bank. In this sense, wholesale and retail digital currencies represent sovereign currency—the central bank’s liabilities.
The idea of a digital currency issued by a central bank for the public is not new. In 1987, James Tobin mooted the concept of a “deposited currency”, or “a medium with the convenience of deposits and the safety of currency”. As per Tobin’s idea, not just banks but individuals would hold deposits with the central bank. The underlying logic of this idea was safety since bank deposits, although convenient, were susceptible to bank runs.
India is not the only (or even the first) country to explore digital currencies. The CBDC global tracker reveals that 11 countries have fully launched a digital currency as of date. The first live retail CBDC was the Sand Dollar, issued by the Central Bank of Bahamas in October 2020, with Jamaica’s JAM-DEX being the latest one. China, which launched its pilot to cover 260 million people, will expand it to the rest of the country in 2023. In 2023, 20 countries will either undertake or extend their pilot testing of digital currencies, while 114 (of the 119 countries tracked), representing over 95% of global GDP, were exploring the launch of a digital currency.
Central banks have been motivated to issue CBDCs due to the rising public interest in Bitcoins and other cryptocurrencies, which pose challenges to traditional forms of money and the central bank-led monetary system. Such cryptocurrencies, however, are mere speculative assets prone to extreme volatility and cannot be used meaningfully as a means of payment. They have also been found to be used to undertake money laundering, ransomware attacks and other financial crimes. Some cryptocurrencies, like Bitcoins, have other negative attributes, such as wasteful energy consumption. For instance, the Bitcoin network currently uses as much electricity as the Netherlands.
However, the competition posed by cryptocurrencies is only one of the reasons for the introduction of CBDCs.
Various countries have justified the adoption of CBDCs for diverse reasons. Sweden, for instance, has sought to popularise a more acceptable electronic form of currency, even as it faces a declining usage of paper currency. Countries like Denmark, Germany, Japan and the United States with significant physical cash usage use CBDCs to make issuance more efficient. Where the geographical spread of the country poses constraints, such as in the Bahamas and the Caribbean islands, CBDCs obviate the need for the physical movement of cash.
In India, the RBI has sought to introduce CBDCs to reduce the operational costs associated with the issuance of money, transactions and management of physical cash. Since CBDCs do not require holders to possess a bank account, they also carry the potential to foster financial inclusion among the unbanked segments of the population. Other reasons provided by the RBI include “bringing resilience, efficiency, and innovation in the payments system, adding efficiency to the settlement system, boosting innovation in cross-border payments space, and providing the public with uses that any private virtual currencies can provide, without the associated risks”.
Can the RBI expect digital currencies to assist in its monetary policy goals? The answer may not be a clear yes or no.
On the one hand, CBDCs can expand the central bank’s toolkit available for achieving various goals, since they can supply information to the RBI regarding the economy on a real-time basis and are also programmable due to their being digital. When CBDCs are available to all (as retail currencies), the RBI would better understand when households are using the CBDC. It can then act on such information in a targeted manner to improve monetary policy effectiveness. It has been estimated that the US could experience as much as a 3% permanent increase in GDP through such increased effectiveness. During times like the pandemic, such information can also be used by central banks to transfer money to those who need it the most, rather than the ‘helicopter drops’ followed by most major central banks.
On the other hand, during economic instability or a system-wide bank run, CBDCs can induce people to switch from relatively riskier bank deposits to risk-free central bank-guaranteed sovereign currency—CBDCs. Such a switch could paradoxically accelerate the bank run.
In India, a key challenge with the monetary policy mechanism has been the considerable lag in the monetary policy transmission mechanism. The solution to such lags could be interest-bearing CBDCs called remunerated CBDCs. These could shift the onus of the transmission from the overnight call money market to the deposit rate directly, thereby ensuring a stronger pass-through of the central bank’s policy rate to the broader structure of interest rates in the financial system. However, the downside of such deposit-like CBDCs could be to encourage people to move away from deposits towards CBDCs, posing a threat to the entire financial system. This is because a loss of deposits to the banks reduces their capacity to create credit through providing loans to firms. On the other hand, unremunerated CBDCs which do not carry an interest rate, like the Indian e₹-R, pose little threat to the financial system through banking disintermediation. However, the trade-off is that such non-interest-bearing CBDCs may not improve monetary transmission.
Thus, while digital currencies have emerged as the sine qua non of a modern monetary system, the issues around the adoption and the efficacy of this new instrument, especially in a country like India, will need to be assessed and monitored in the next few years.
Tulsi Jayakumar
Professor, Economics and Executive Director, Centre for Family Business & Entrepreneurship at Bhavan’s SPJIMR
(Views are personal)