Why is the Government introducing CBDCs? What will be the risks in the transition to a new monetary system?
The story so far: In the Budget presented for 2022-23, Finance Minister Nirmala Sitharaman had announced the introduction of India’s Central Bank Digital Currency (CBDC) and that the digital rupee would give a ‘big boost’ to digital economy. She had indicated that technologies such as blockchain would be used by the Reserve Bank of India to issue the currency, starting 2022-23. The Reserve Bank had, in July 2021, indicated that it would soon begin work on the ‘phased implementation’ of the CBDC.
- In the 2022-23 Budget, Finance Minister Nirmala Sitharaman had announced the introduction of India’s Central Bank Digital Currency (CBDC). A CBDC is no different from physical cash, except that it would exist in a digital form. The CBDC will be held in a digital wallet that is supervised by the RBI.
- Central banks claim that there is an increasing demand for digital currencies as is evident from the rise of private digital currencies such as bitcoin and the increasing use of digital payments. Central banks also believe that the cost of issuing digital currencies is far lower than the cost of printing and distributing physical cash. The RBI can create and distribute the digital rupee at virtually zero cost.
- Many fear that people may begin withdrawing money from their bank accounts as digital currencies issued by Central banks become more popular. The withdrawal of bank deposits can also affect the amount of loans created by the banks.
What is a Central Bank Digital Currency?
A CBDC is no different from the cash that we hold in our wallets, except that it exists in a digital form. The CBDC will be held in a digital wallet that is supervised by the Central bank. In India, it will be the RBI that supervises the digital rupee although it may delegate some power to banks. However, it does seem probable that the RBI will take steps to encourage the use of its digital currency over physical cash. It should be noted that the RBI’s digital rupee will not directly replace demand deposits held in banks. Physical cash will continue to be used by banks, and people who wish to withdraw cash from banks can still do so. But they can also opt to convert their bank deposits into the new digital rupee.
Why are central banks issuing digital currencies?
Central banks claim that there is an increasing demand for digital currencies, which they wish to satisfy. They point to the rise of private digital currencies such as bitcoin and also to the increasing use of digital payments as examples of this secular trend. Central bank digital currencies are promised as reliable, sovereign-backed alternatives to private currencies which are volatile and unregulated. Critics, however, note that the demand for private currencies comes primarily from people who have lost faith in fiat currencies issued by Central banks. They argue that governments across the world have been debasing their respective currencies by printing them in excessive amounts, thus forcing many to switch to private currencies whose supply is limited by design. So the mere digital version of a national currency like the rupee or the U.S. dollar is unlikely to affect the demand for private currencies, they believe.
Central banks also believe that the cost of issuing digital currencies is far lower than the cost of printing and distributing physical cash. The RBI can create and distribute the digital rupee at virtually zero cost since the creation and the distribution of the digital rupee will happen electronically. Another likely reason for the introduction of digital cash may be to bring down the use of physical cash. Unlike physical cash, which is hard to trace, a digital currency that is monitored by the RBI can be more easily tracked and controlled by the Central bank. This feature of digital currencies, however, has raised various concerns regarding their privacy and could slow down their adoption. In fact, it is worth noting that the need for privacy has been one of the primary reasons behind the switch to private digital currencies.
Is CBDC becoming common across the world?
It is worth noting that several countries, including the United States, those in the European Union and China, have been working seriously towards issuing their own Central Bank Digital Currency (CBDC) in recent years. In October 2020, the Bahamas launched the world’s first CBDC. However, a few countries, including Finland and Denmark —have taken a step back and have said they had cancelled efforts to introduce a digital currency, according to CBDCTracker.org.
In a 2017 note, Denmark’s central bank indicated that it was “unclear what central bank digital currency would be able to contribute that is not already covered by the current payment solutions.”
It added that the potential benefits of introducing CBDC in Denmark were not “assessed to match the considerable challenges that this introduction would present."
What are the risks in adopting digital currencies issued by Central banks?
Many, including various central bankers, fear that people may begin withdrawing money from their bank accounts as digital currencies issued by Central banks become more popular. This concern was flagged by the RBI Deputy Governor as well. Remember that many people currently use bank accounts to safely store their cash. When the digital wallet offered by the RBI can serve the same purpose, people could very well begin converting their bank deposits into digital cash.
One thing that could prevent any large flight of capital from bank accounts to digital currencies is the fact that bank accounts, unlike digital currencies, offer interest on deposits. But in developed economies, where interest rates are near zero or even negative, the risk of people rushing their money out of bank accounts and into digital currencies is real. This may not be an immediate concern for banks in India which still offer returns that are positive, at least in nominal terms, to their depositors.
The withdrawal of bank deposits can also affect the amount of loans created by banks. However, this could happen not simply because banks will have fewer cash deposits to lend to borrowers. Contrary to popular belief, banks do not loan out actual cash deposits. Instead, they use cash deposits as a base on which they create a pyramid of electronic loans far in excess of the cash deposits. So banks hold lower amounts of cash in their vaults than what their depositors and borrowers could demand from them anyway. The real reason banks will be able to create fewer loans is that when customers convert their bank money into CBDCs, banks will be forced to surrender at least some cash and will thus possess an even smaller base on which to create loans. Also, when bank customers convert their deposits into digital rupee, the RBI will have to take these liabilities from the books of banks and onto its own balance sheet.
What lies ahead?
There is speculation already that Central banks will cap the amount of money that an individual can hold in the form of CBDCs. This is to prevent the mass withdrawal of deposits from banks. Some even believe that some Central banks, such as the European Central Bank, may impose a negative penalty on their digital currencies. This could be done to force people to spend their digital currencies and to discourage the withdrawal of deposits from banks that impose negative interest rates.
Central banks may also have to inject fresh money into banks to ensure that the ability of banks to create loans is not affected by depositors’ rush to digital currencies.
(With inputs from K. Bharat Kumar)
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