Can India’s central bank digital currency (CBDC) replace paper money?

In India, the ratio of CIC to GDP fell from 12.09% in March 2016 to 8.75% in March 2017 due to demonetization

Author | Prof. J. Meena Kumari

Source | International Journal of Management

Introduction
Money has three main uses: (i) for payment and settlement of goods and services; (ii) for storage; and (iii) to provide a unit of account. In the financial system, money is known as the most liquid asset and is used as a benchmark for assessing the liquidity of institutions/systems.

An important characteristic of money is its broad acceptability, although its “face value” is much higher than the actual value of the paper. Therefore, one of the important aspects of currency management is people’s confidence in the currency, which depends to a large extent on confidence in the central bank and the government. In India, the rupee has wide acceptance and has never faced a crisis of confidence despite its devaluation due to inflation. People have also not lost interest in the Indian rupee for storage purposes.

Demand for notes and coins has steadily increased despite the growing use of technology-driven, non-cash payment methods. The demand for notes is influenced by a variety of socio-economic, behavioral and other often unpredictable factors. The main reasons for the high reliance on cash are financial exclusion and the informal or black money economy of the state.

Even for customers with bank accounts, distance to bank branches, travel costs, opportunity costs of time spent, and complex documentation are important reasons for low account usage and increased cash usage. From the end of June 2019 to the end of June 2020, the value of banknotes in circulation increased by 22% to Rs 26,356 billion.

Can India's central bank digital currency (CBDC) replace paper money?

The Currency in Circulation (CIC) to GDP ratio gives a picture of the level of currency use relative to GDP growth, which also facilitates comparative analysis with other countries.GDP growth is one of the main drivers of CIC. As in 2016, the world average ratio of CIC to GDP is 9.6% (compared to 8.1% in 2011). Africa, Asia and Europe are on par with the global average, while North America, and Oceania in particular, are below the world average. South America has the highest cash dependence relative to its GDP. The ratio of currency in circulation to GDP is increasing across all continents, indicating a continued increase in global demand for cash. Sweden has the lowest cash dependence, with a CIC to GDP ratio of 1.4%, while Paraguay’s ratio is 38%.

Can India's central bank digital currency (CBDC) replace paper money?

In India, due to demonetization, the CIC to GDP ratio declined from 12.09% in March 2016 to 8.75% in March 2017. The CIC to GDP ratio has been on a downward trend over the past decade, declining from 12.6% in 2010 to 12.0% in 2020. Many experts believe this figure indicates a downward trend in cash use. As the table below shows, cash use as a percentage of GDP has been declining between 2010 and 2015 and has never reached its peak of 12.6% in 2010. This period also corresponds to the continued high growth of digital payments in India, indicating a significant shift in the choice of retail payments from cash to digital payments, setting the stage for the introduction of CBDC.

Can India's central bank digital currency (CBDC) replace paper money?

Against the backdrop of such developments, the Indian government proposed in the 2021 budget session to introduce the “Official Digital Currency Bill 2021”, which aims to “create a framework for digital currencies issued by the Reserve Bank of India”. The bill also seeks to ban all private cryptocurrencies in India, but it allows for certain exceptions to promote the technology underlying cryptocurrencies and their use. the ground is ready for the CBDC. The success or failure of this experiment will depend on three factors related to cryptocurrency, namely acceptability as a medium of exchange, security and privacy as a means of storing value, and stability as a unit of account for economic and financial transactions. In short, the CBDC issued by RBI should also provide the same confidence in the Indian rupee, offering the same convenience and privacy as a currency.

Background
The idea of providing a currency without any central bank backing first emerged in 2008, when Bitcoin was defined as “a publicly available means of transaction through a blockchain that combines decentralized control, user anonymity, record-keeping, and built-in scarcity”.

The first bitcoin was introduced in early 2009, followed by several other cryptocurrencies, such as Litecoin. Bitcoin’s acceptance began to grow as platforms such as WordPress, Expedia, and even Microsoft gradually accepted Bitcoin. Many Bitcoin and other cryptocurrency holders began exchanging these currencies for fiat currency, and the cryptocurrency space became widely attractive to investors and users alike.

Many websites promote gambling through the use of cryptocurrencies, and international regulators such as the Financial Action Task Force (FATF) have begun issuing globally binding directives to prevent the misuse of cryptocurrencies in money laundering and terrorist financing.

In India, cryptocurrencies are considered illegal activities according to an April 2018 RBI circular, but on March 4, 2020, the Hon’ble Supreme Court lifted the ban on cryptocurrencies and asked the RBI to use its powers to regulate and ban cryptocurrencies. It provides some legitimacy to cryptocurrency trading in India, but despite the trading capabilities of cryptocurrencies, their presence in the virtual currency world is insignificant. If the proposed Cryptocurrency Bill 2021 comes into effect, all such transactions could once again become illegal, and the CBDC could launch and use the underlying technology that makes such virtual currencies popular. However, if the “built-in scarcity” promise made by Bitcoin’s founders reflects the characteristics of cash, then it may not be realized in CBDCs. In India, the availability of cash is demand-driven, and one of the goals of currency management is to make sufficient cash available in all areas of the country based on people’s needs and requirements. Therefore, CBDC must be available within the limits of demand, which also prevents the use of CBDC as a rare commodity, making its price highly volatile relative to popular fiat currencies such as the U.S. dollar.

While the commodity nature of cryptocurrencies can be eliminated with wider availability in CBDCs, the underlying distributed ledger technology (DLT) remains a hindrance, as mining cryptocurrencies becomes more difficult as the user base grows. In a country like India, technology choice will be the main challenge for introducing cryptocurrencies.

Challenges of introducing CBDC in India
I would like to highlight two trends related to SNB here. The first and most obvious move towards a digital economy is the changing payment methods, with the increasing use of mobile payments. The second obvious trend is big data and automation, especially involving artificial intelligence. In addition to these two trends, cyber risk is growing.

Robust and secure technology

Currency management is a core function of the central bank. The Reserve Bank of India ensures that the legitimate public demand for banknotes and coins is met. India’s currency management structure consists of 19 RBI offices across the country that provide banknotes and coins in currency boxes (CCs), which are containers managed by commercial banks, cooperative banks and regional rural banks. As of March 31, 2020, there are 3,367 currency boxes across the country that actively provide currency to remote areas. Almost all bank branches are connected to these CCs and these branches deposit or withdraw money from these CCs according to public demand. At the end of the day, these CCs report the total amount of deposits and withdrawals to RBI, which then derives the total amount of currency in circulation. As of January 22, 2021, the total value of currency in circulation is Rs. 278,454 crores. The introduction of CBDC requires consideration of India’s monetary needs and the architecture required to meet that need. Developing robust and secure technology to calculate the transactions in CBDC will be a huge challenge.

Can India's central bank digital currency (CBDC) replace paper money?

Digital platforms and digital payment methods

Another challenge to introducing CBDC in India will come from the digital platforms and digital payment methods that have started to gain popularity in recent years. As a digital currency issued by the central bank, CBDC should not be one of the many products available in the virtual space. It must have unique characteristics that provide novelty and unique usage of the commonplace.

Internet Connectivity

Financial inclusion has not been very successful because Internet connectivity and related issues have been a challenge in remote mountainous areas, and this will be a major obstacle to providing paper money for CBDCs. If CBDC relies on any type of connectivity, it will deprive a portion of our population of the benefits.

Ease of Use

Finally, while currency remains a necessity for every citizen in the country, not every citizen is financially and technologically literate, so ease of use will also be a challenge to introducing CBDC.

Risks associated with CBDC
First, in the virtual world, the main risk is cyber attacks on infrastructure and end users. As technology becomes ubiquitous, this threat will be pervasive.

Second, operational failures could have a devastating impact on many CBDC users. Connectivity issues, power outages, and natural disasters are the primary risks to operational failure.

Third, each system has a limited capacity at any point in time, and the volume of transactions in a CBDC could pose significant challenges to ease of use for end users.

Fourth, just like India’s currency, CBDCs need to have legal status in order to be given the characteristics of legal tender for wider acceptance.

The ideal model for CBDC in India
The architecture used for cash management provides an immediate and ready-made structure for introducing CBDCs. As noted elsewhere in the study, the currency box provides the interface between the public and the RBI for the provision of cash to the general public. Banks withdraw funds from the CC in order to meet public demand. In a country like India, the same model applies to CBDCs. RBI can issue CBDCs from its counters in 19 locations or through CCs across the country that can be managed by the bank and act as a tangible exchange for CBDCs.

CBDCs can be in the form of tokens or digital currencies, just like Bitcoin. Those who understand and enjoy using virtual currencies can subscribe to the digital currency and own their money in digital form. This would facilitate payments and settlements in a cross-border virtual world. End users should have a mechanism to verify the authenticity of CBDC, so DLT can be the best option for CBDC in digital form. Each CC can act as an exchange for digital currencies and therefore can manage its own set of users through DLT. All CCs can be linked to the common technology platform and provide real-time quantities of CBDCs at any point in time.

The above model provides a solution for cross-border trade in the virtual space. However, in a country like India, digital currency alone does not guarantee the success of CBDCs. The Indian model of CBDC should also use tokens like a plastic card with a screen that provides face value information at all times. token should essentially have the capability to provide peer-to-peer transactions via a contact point on the card or non-contact transactions or provide offline peer-to-peer transactions. The ability to connect to other cards for transactions without data or mobile devices could be a new feature of CBDC India. This would provide wider acceptability of such tokens, which could emerge as an alternative to cash even in small, remote locations. Such tokens could have a value cap and could be periodically authenticated for further use through an application or device. During such authentication, the value of the CBDC can be recorded in a central server for bookkeeping purposes. However, given the large number of cryptocurrency tokens, DLT may not be the ideal technology choice for calculating tokens. CBDCs need a mix of blockchain and other categorical bookkeeping technologies to provide both online and offline exchange facilities. This diagram shows the possible architecture of CBDC in India.

Can India's central bank digital currency (CBDC) replace paper money?

Each CC, as an exchange, should have information about virtual currency users to comply with FATF guidelines to prevent money laundering and terrorist financing. Virtual currency users cannot trade in illegal goods or services. However, CBDC can be used for any cross-border transaction payment settlement in a legal manner. It can also be interchanged with legal virtual currencies issued by other central banks. This will facilitate the use of CBDC in cross-border trade in a safe enough manner.

Token currencies can have loose norms to provide cash. Tokens can have different colors and different caps, and can be freely exchanged between users who are regularly certified by the universal application. The tokens will continue to be linked to the issuing CC, which will be used as settlement and verification through the application. Each time a user verifies a physical token through the application, the CC will capture the current value of the token and the ledger value will be updated. Finally, the ledger value of all CCs and RBIs will be updated through distributed ledger technology.

Conclusion
Despite the significant growth in digital payments, cash remains the king of the Indian payment and settlement system. the volume of CIC is too large to be replaced by CBDC, and even after the introduction of CBDC in India, cash will still be needed in the medium term. In the initial stages of CBDC, transaction volumes can be limited to 1-2% of CIC to monitor its usage. the growth of CIC needs to be driven by technology, as a hassle-free transaction experience can lead to its wider acceptance. Therefore, for CBDC’s success in India, robust technology and a secure environment are key factors.

CBDC has the potential to be the largest digital trading platform in any country, so the challenges associated with cyber threats are likely to be greater than any existing digital trading platform in the country. Prudent growth and adequate security are key to CBDC’s success.

The benefits of CBDC for users include easy storage and transactions, privacy and security, bank accounts without financial intermediaries, and easy access to benefits and subsidies. For central banks, the primary motivation for issuance is continued monetary sovereignty and cost effectiveness compared to printing money and other cash management related costs. In addition, CBDCs offer exciting possibilities for implementing monetary policy. In the fight against money laundering and terrorist financing, CBDCs offer the opportunity to better track financial flows. CBDCs appear to be more attractive and promising than cash for all stakeholders, and have real potential to replace banknotes and coins in the long run.

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