India plans to launch a Central Bank Digital Currency (CBDC). A CBDC is seen mainly as a substitute for cash and for cryptocurrencies. It is supposed to be both a medium of exchange and an asset. However, whether or not it’s widely adopted will depend upon its usefulness as a substitute for cash, and its attractiveness as an asset.
After a recent speech by a Reserve Bank of India (RBI) official saying that cryptocurrencies should be banned, it appears that the RBI is hoping that its CBDC can be posed as an alternative to cryptocurrencies.
However, in India, cryptocurrencies such as bitcoin are seen more as assets than as a medium of exchange. Unlike in the US — where many entities including some Ivy league schools are accepting bitcoins for payment of fees — in India, cryptocurrencies are largely seen as instruments to diversify risk and act as a hedge against swings in other asset classes.
The value of an RBI-issued CBDC is expected to be stable. This limits its attractiveness as an asset. Thus, in India, the CBDC is more likely to be used as a medium of exchange than as an asset.
Next, for the CBDC to be an attractive medium of exchange, it has to be more attractive than alternatives such as cash, bank deposits and digital wallets.
Would an RBI CBDC be a good substitute for cash? A CBDC is a central-bank-issued digital money denominated in a sovereign currency. It appears on the balance sheet of the central bank as a liability. A CBDC is the same as physical cash — only its form is different; it’s not printed on paper. It will be safer than holding cash that can be lost or stolen, but it may require robust technology and pervasive mobile connectivity.
Second, is a CBDC a good substitute for digital wallets or pre-paid instruments (PPIs)? Yes, on this measure, it appears so. This is because a CBDC would be legal tender. A legal tender instrument is recognised by law and must be accepted if offered as a means to settle a transaction.
In India currently, bank notes issued by the RBI are legal tender. The Finance Bill, 2022 has proposed amendments to the RBI Act to facilitate the issuance of a CBDC as legal tender. The amendment introduces a definition of bank notes to include both physical and digital forms.
Pre-paid instruments facilitate the purchase of goods and services and fund transfers against the value stored on such instruments. While PPIs like Paytm are authorised by the RBI for the purchase of goods and services, they are not legal tender. They can only be used in cases where an entity accepts the payment instruments. An RBI CBDC could affect the business of payments banks as it could replace wallets.
In addition to cash, bank deposits can also be used as a medium of exchange, whether through cheques or through bank transfers. In that sense, they are also money. While bank deposits are a liability of commercial banks, CBDC would be a liability of the central bank, and thus carry no risk.
If the CBDC is intended to be used as a digital equivalent of cash by households and businesses, it is referred to as a “retail” CBDC. However, if it is restricted to financial institutions and is intended primarily for settlement of large inter-bank payments, it is referred to as a “wholesale” CBDC.
The RBI has said that it is considering pilot projects in wholesale and retail segments in the near future. While a wholesale CBDC would be used for limited purposes, the implications of introducing a retail CBDC need to be carefully understood.
Rollout of a retail CBDC would require pervasive internet connectivity and an efficient telecommunication network for transacting in CBDCs. Further, as the central bank will maintain retail balances, the choice of technological architecture assumes significance. The complexity of the underlying technology may limit its adoption by households. Moreover, the underlying technology should be able to process payments efficiently and fast.
Interest on CBDCs
The payment of interest on a CBDC would likely enhance its attractiveness. If it offers attractive interest rates, households could have the incentive to move their deposits with banks to the CBDC. If CBDCs compete with bank deposits, banks may respond by increasing interest on deposits. This would necessitate lending at a higher rate to preserve their margins. An interest-bearing CBDC could thus increase the cost of credit.
Another element of the discussion is the extent to which bank deposits will be reduced by the issuance of a CBDC, as no bank credit will be created on its basis. Credit supply will shrink accordingly.
Many central banks have been stepping up work on exploring the introduction of CBDCs. But so far, only 9 countries including Nigeria, China, and The Bahamas have fully launched a digital currency. Most other countries are exploring the objectives of doing so. Before India joins the list above, Indian policymakers should be clear about what the gaps are and what they are trying to achieve with a CBDC.
Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.
Radhika Pandey is a consultant at NIPFP.
Views are personal.