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You can’t coerce India to adopt digital payments. Here’s what Modi govt should try instead

Those who invested in or built standalone payment firms might be regretting because Modi govt’s move to remove MDR has harmed their business model.

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For years, the Narendra Modi government has made the promotion of digital payments a priority. In its latest move, the government last month amended the Income Tax Act, 1961 and the Payment and Settlement Systems Act, 2007 doing away with the merchant discount rate – charges levied on digital payments.

So far, the Modi government’s strategy to promote electronic payments has been a mix of coercion, persuasion, and incentives. This latest move is mostly coercive.

The Modi government plans to prescribe specific modes of digital payments, which, under the Income Tax Act, will have to be provided by every business outlet with a turnover of more than Rs 50 crore. Going by Finance Minister Nirmala Sitharaman’s Budget 2019 speech, these may include BHIM UPI, UPI-QR code, Aadhaar Pay, certain debit cards, NEFT, and RTGS. There will be a penalty of Rs 5,000 for each day of non-compliance, to be enforced by the joint commissioner of Income Tax.

Moreover, payment service providers will have to offer the instruments prescribed above free of cost, with the Reserve Bank of India and banks mandated to absorb the cost of transactions. This amendment to the Payment and Settlement Systems Act was done through the finance bill, which was a money bill. The amendment does not seem to pertain to the matters listed in Article 110 of the Constitution, which defines the scope of money bills.

Also read: Paytm, PhonePe, Amazon, Google help push UPI payments past 1 billion transactions

MDR, the main source of income

In a market with competing instruments, the Modi government is forcing businesses to offer the instruments it prefers, while prohibiting payment service providers from charging for these instruments. Going by the past experience of subsidy on debit/UPI transactions, the promise that the RBI and banks will absorb the costs will at best mean that only a nominal reimbursement will be made.

The main source of income that oils the machinery of digital payments, from the issuance of cards to the point of sale infrastructure for accepting payments, is the merchant discount rate (MDR). This is the charge levied on each electronic payment, which is usually absorbed by the merchants, albeit ultimately in any business the incidence of all charges is on the consumers.

MDR is regulated. A lower MDR is mandated for debit card transactions. MDR is 0.9 per cent on debit cards and 1.8-1.9 per cent on credit cards.

A debit card, a UPI or an Aadhaar-enabled transaction up to Rs 2,000 has been made free since January 2018, with the Modi government agreeing to reimburse 0.4 per cent of the transaction amount to the banks (which will then reimburse that amount to the payment service providers) for a period of two years.

Also read: India has a long way to go to squeeze cash out of the economy & become digital

Five forms of disruption

The government’s decision to prohibit the pricing of its preferred instruments takes this price regulation too far. It is likely to have a disruptive effect on the entire payments sector.

First, all payment instruments will be affected by the decision to remove MDR. It will be difficult to offer other instruments because they will be competing with instruments that are free. This is essentially government-mandated predatory pricing.

Second, the incentive of payment service providers to focus on the quality of services will weaken considerably. The service providers must have the incentive to respond to the needs of consumers. The payments business appears to be a simple utilities business, but it is not. Even though digital payment is only a transfer of money from one account to another, there is a lot that goes into the process before and after that transfer happens. The payment service providers create awareness among consumers and solve problems for them. In India, there is still a long way to go before people become comfortable using electronic payments.

Third, the decision will weaken the incentive to expand the payment infrastructure to more merchant locations. While the larger establishments will offer electronic payments, the payment service providers will have little incentive to go beyond those establishments. MDR pays for the costs of convincing, training, equipping, and assisting merchants to accept digital payments. A key challenge in increasing the adoption of digital payments is merchant acquisition.

Fourth, this move will force bundling of payment services with other services, because only those firms that provide payment services in addition to other services will be able to offer it. These may include banks, retail chains, telecom companies, etc. In recent years, we have seen some unbundling of payment services, with the emergence of more standalone payment service providers. Such firms will struggle to survive because their business model rests on the ability to charge for payment services.

Fifth, the decision weakens the incentive to invest in innovation in the digital payments industry. Investors usually take risks with the objective of making money. An easy way to kill innovation in any sector is to prohibit the firms from charging for their services.

Also read: Banks better watch out, the fintech payment revolution is coming

Need for fintech

In the government, it is a strangely persistent belief that the use of such coercion is a good way of achieving inclusion. Rarely does the government allow the markets to find ways to reach the consumers through competition and innovation. When it does, the results are usually good.

Mobile telephony is an example. Over the last twenty years, competition and innovation have brought down the price of mobile services by more than 99 per cent. Competition has forced firms to pursue scale and efficiency-enhancing innovation, and so prices have gradually fallen. Imagine if, in 1999, the government had forced the mobile companies to price the calls at a low rate to “promote mobile telephony”. The business model would have become non-viable. Firms might have survived by servicing the densely populated areas, but they would not have been able to invest in new technologies and in deepening the market.

The advent of fintech (financial technologies) can disrupt old business models by creating new ways of designing and providing financial services. Given the rapid adoption of technology in India, we have an opportunity to leapfrog in the usage of financial services by deploying fintech.

However, this will require a conducive policy environment. Those who invested in or built standalone payment firms in recent years might be regretting their decision because this sudden move of the Modi government to remove MDR has harmed their business model. We in India are quite used to such arbitrary interventions in the economy. The statist mindset of command and control that gives rise to such decisions is not going away any time soon. This raises the question: can fintech really thrive in such a policy environment?

This article is part of a series examining The Future of Data in partnership with Carnegie India leading up to its Global Technology Summit 2019 in Bengaluru from 4-6 December 2019. More details about the summit are available here

The author is a Fellow at Carnegie India. Views are personal.

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