• Research & Analysis Services I Academic I Market & Industry I Government Policy I
Clarifying Concepts
Impact of Central Bank Digital Currency (eRupee) on India’s Future

Impact of Central Bank Digital Currency (eRupee) on India’s Future

Table of Content

  • Initiation of CBDCs in the World
  • What is Digital currency?
  • How CBDCs are getting developed?
  • Difference between UPI Payments & CBDCs
  • Impact on Monetary Policy and Forex
  • India’s Future and Concluding Remarks

Initiation of CBDCs in the World

The beginning of 2023 has marked several advances in daily use AI technology, kick starting multiple races amongst the upper echelons of corporate and government hierarchy. Although the epitome of this has been ChatGPT, there is also a surge of government action in another domain, the ‘Central Bank Digital Currency’ or CBDCs.

With multiple countries setting up commissions and cross departmental research groups to explore this possibility, India has been one of the first few countries to actually try and implement it since December 1, 2022.

Accordingly, RBI has authorized several commercial banks to give trial access to their customers across 15 pilot cities. Along with India, there are 105 other countries considering the shift according to the Atlantic Council’s Central Bank Digital Currency Tracker.

Among them, Nigeria has come out as one showing serious initiative, being among the only 3 countries with a solid CBDC infrastructure in place and their digital currency ‘eNaira’ already in circulation.

Similarly, China has been a pioneering force in terms of their domestic CBDC debut. It is currently, undertaking the largest CBDC pilot in the world where they have 260 million active wallets amounting to a 13.61 Billion RMB in circulation..

Thirdly, and most surprisingly, the Bahamas, despite being a small island nation relatively faint in its depiction in public media, was the first country in the world to debut a nationalized CBDC in 2020.

What is Digital Currency?

The onset of this idea is definitively rooted in the large scale adoption of crypto currencies such as Bitcoin and Ethereum as tradable assets in digital financial markets across the world.

This onset however, pushed us back to a question at the very cornerstone of our economic and financial discourse. The definition of money to this day is only limited to the description of its functions as a store of value, a medium of exchange, a unit of account, standard of deferred payments and so forth.

Yet what makes money so fundamentally appealing and generally acceptable is that each currency is backed as legal tender by its particular Central Bank, like the RBI in India and the Federal Reserve in the USA. As a legal tender, currency has people’s trust. This, in effect, also serves as a reminder to us about how much of the modern economy still relies on a general systemic faith that people have on economic institutions and their accountability. A point we must remember for later on in the article.

The onset of crypto currencies on the financial markets scene robbed the definition of this trust factor, as crypto was formulated as a decentralized model which operated free of any Central Bank regulatory authority over it. It was however, on this same basis that experts from the economic fraternity vehemently objected to the acceptance of crypto as a form of ‘money’. Rather than a medium of exchange for real world goods and commodities, crypto was bridled as a mere asset class which could be traded in financial markets, but not used as a token to buy things with.

Jerome Powell, the incumbent Chairman of the US Federal Reserve even said, “…the ultimate source of credibility in money, is the Central Bank”.

It is also due to loose regulations governing crypto markets that resulted in the recent fall of FTX, a platform for crypto exchange just like the BSE or NSE is for Fiat Money (legal tender currency backed by the Central Bank).

Besides regulatory issues, crypto markets have historically been forced to deal with high price volatility and a lack of inherent value independent of supply and demand factors. As a commodity, they are useless in the real world. Although an alternate version of crypto currency, called stable coins, which pegs the value of crypto against a real world commodity like gold, or USD, exists, the problem of larger cyber security still persists.

Despite bold efforts by Central banks worldwide to discredit crypto currencies of their fame, the sheer technological sophistication of these systems is difficult to disregard entirely. Crypto currencies are set on blockchain technology.

In short, a blockchain is a digital infrastructure that creates a DLT (Distributed Ledger Technology), a digital ledger which verifies and immutable records transactions through a peer to peer network of computers (called nodes). This digital ledger revolutionizes traditional ledger accounts that commercial banks hold, eliminating the inefficiencies and increasing transparency of data between all participants of the business network. It boosts a systemic trust within the network which is now reliant on technology to suit their accounting needs rather than the fallibility of a bank or government institution. It was here that the idea for a CBDC gained traction.

How CBDCs are getting developed?

CBDCs are a digital currency backed by the Central Bank of a country. There are two clauses within this previous sentence that provide clarity into the matter. Firstly, CBDCs are also a digital currency similar to crypto, where they will be based on blockchain systems. Secondly, distinguishing them from crypto, CBDCs will be backed by central banks where they will be legal tender, considered as fiat money. Case in point, they can be utilized for day to day retail and merchant transactions by customers.

CBDCs are meant to solve the problem of inherent value that crypto faces, by creating a digital form of the existing national currency circulating in the economy, such as the Chinese eCNY, which is a digital Yuan. Where crypto couldn’t be used as legal tender to support daily payments, but CBDCs can. They retain the general acceptability function of traditional money.

Difference between UPI Payments & CBDCs

It is also crucial to note the difference between India’s advanced digital payments UPI system, and the CBDC system.

UPI is a payment gateway, through which traditional currency can be transferred from one customer account to another; whereas CBDC, is a new form of money in itself. UPI requires the customers to have a bank account. CBDCs can operate, by the RBI directly opening a wallet for the customer even those without bank accounts.

The World Bank estimated in a 2018 report that 82% of Indians have bank accounts. The subsidiary aim of CBDCs is also to increase financial inclusion for those without this facility and also for those who have bank accounts but don’t utilize banking facilities.

In India, the RBI launched a CBDC pilot in a two tier system, a wholesale model (CBDC-W) which will be used for inter-banking payments and cross institutional operations, and secondly a retail model (CBDC-R) which will be made accessible to the general public for their daily use retail transactions.

India’s plan in this regard is to give deterministic nodal access to each commercial bank through which this digital currency (eRupee) can be circulated amongst the public. However, an Indian Finance Ministry survey found that 52% of their respondents preferred to still save money at home rather than in banks.

Thus how the RBI plans to increase financial inclusion goals complementary with their CBDC implementation remains to be seen.

Impact on Monetary Policy and Forex

The International Monetary Fund (IMF) in the March of 2023 published a thorough working paper titled ‘Monetary Policy Implications of Central Bank Digital Currencies’ giving insights into the challenges that monetary authorities in governments will be faced with if CBDCs were to be launched into common usage.

The paper highlights that CBDCs won’t change the framework or objectives under which monetary policy works, but it would produce immediate negative spillover effects into its implementation and transmission.

The primary concern is that due to the high speed efficiency of CBDC technology compared to traditional means, money velocity will exceed the banks’ ability to control cash flows. Money velocity is simply, the rate at which consumers and businesses in an economy spend money. Increase in this variable can substantially increase volatility of commercial bank reserves with the central bank. This can have vast negative consequences on the central bank’s ability to forecast money supply trends and conduct open markets operations (OMOs) or exercise credit control measures to curb inflation.

In short, strong inflationary tendencies might be a considerable threat to economies relying heavily on monetarist principles.

The IMF predicts that countries most susceptible to these new changes are ones where non-interest bearing, unremunerative demand deposits are high and small transactional retail deposits are dominant. This makes them vulnerable to high-speed high-liquidity transactions which will strain the central bank’s ability to maintain cash reserves and make money supply forecasts.

Additionally, one of the key objectives of Central Banks is also to control and stabilize exchange rates to ensure the country’s Foreign Exchange (FOREX) reserves and trade transactions remain uniform according to need. Parallel, as several countries plan to extend the scope of CBDCs to cross-border payments and remittances, the higher velocity of money also warrants the central banks to improve their technical infrastructure attuned to the new blockchain landscape.

Theoretically, monetarist perspectives work on the assumption that nominal expenditure/income and thereby inflation in the economy can be regulated using money supply controls provided money velocity remains relatively stable. The externally caused changes in money velocity is also what rendered monetary policies futile during the 1980s in the USA. Granted the incoming changes that CBDCs bring, this challenge is bound to resurface, therefore requiring novel means of credit control suiting the new landscape to be considered.

According to the IMF Working Paper, in terms of cross border payments, for both issuing and recipient countries, faster access to cross border settlement could cause liquidity to flow rapidly from one currency asset market into another. The increased speed in cross border payments could amplify capital flow volatility that affects the domestic monetary authorities’ ability to manage exchange rate and monetary policy.

An upsurge in the use of CBDC-W for cross-border settlement could also result in higher and possibly more volatile intraday demand for central bank money. Access to intraday CBDC-W by non-resident banks could increase demand for the overnight reserves held by resident banks acting as correspondents. If this were to happen, it may affect liquidity management by market participants, the price for liquidity and, consequently, the transmission of monetary policy.

Similarly, a sudden inflow of foreign currency in a recipient country can undermine the authority of their own monetary authority by causing currency substitution, a situation where the majority of the circulating currency in an economy is foreign and not controlled by its own central bank.

All of these are serious considerations to be accounted for in terms of a country sovereignly managing its exchange rates and regulating money supply.

India’s Future and Concluding Remarks

Amidst all the rapid R&D progress taking place, with multiple countries rushing to jump on the bandwagon, a compelling question facing us is, what are the geopolitical changes this might thrust upon the world order?

The answer lies in one term, status quo.

The generally held view is that countries with a fully-fledged CBDC infrastructure in place will have an absolute edge over those without.

The high speed and liquidity offered by this technology will make it efficient and more preferable in terms of conducting international trade. Moreover, the technology to govern this system comes at a hugely lesser cost compared to traditional currency, which has the possibility of reducing the tax burden on international trade and forex.

India estimated that USD 664 Million a year could be saved by substituting the UPI payment gateway with a CBDC. Further, it has been estimated that adoption of CBDCs would reduce over USD 600 Million annually spent on the printing and circulation of the Indian currency. This substitution can give India an upper hand to be considered as a reserve currency globally.

The USA has been advocating the advancement of Stable coins pegged to the USD so far to maintain the USD’s status quo.

All in all, and despite all the monetary challenges stated above it is essential to note that these advancements are still in the developmental stage. Although pilot launches are being conducted across Nigeria, Russia, China, India and others, these are merely to test the waters and understand how the public responds to these changes.

Although the central banks can vaguely forecast what technical and structural challenges this process might bring forth, they cannot accurately predict the public’s response to it.

The key to manage this change is to take a tier in tier, step by step approach which launches CBDCs across several pilots with multiple use case scenarios in question.

Leave a Reply

Your email address will not be published.