Digital Rupee: Advantages and Challenges – Explained, pointwise

Introduction

The Union Minister for Finance & Corporate Affairs has tabled the Union Budget 2022-23 in the Parliament. One of the major highlights of this year’s budget is the announcement of Government’s decision to launch Digital Rupee – India’s version of a Central Bank Digital Currency (CBDC).

The announcement is a reiteration of the SC Garg Committee that had asked the RBI to introduce its own digital currency and ban private cryptocurrencies completely.

What is a Central Bank Digital Currency?

A Central Bank Digital Currency (CBDC), or national digital currency, is the digital form of a country’s fiat currency. Instead of printing paper currency or minting coins, the central bank issues electronic tokens. This token value is backed by the full faith and credit of the Government.

About the status of CBDC at the global level

Currently, 9 countries already use digital currencies. Among the nine countries with active CBDCs, eight are small island nations in the Caribbean. Currently, at least 87 countries are researching or developing CBDCs, including 14 who are running pilot programmes.

1) Sweden is conducting real-world trials of their digital currency (Krona); 2)The Bahamas has already issued their digital currency “Sand Dollar” to all citizens; 3) In October 2021, Nigeria became the latest country to introduce a digital currency, e-Naira. 4) China started a trial run of their digital currency e-RMB amid pandemic. They plan to implement pan-China in 2022. This is the first national digital currency operated by a major economy.

Countries like Japan, Singapore are currently examining the various facets of such a transition. A few days ago, the US Federal Reserve also released a report outlining the costs and benefits of issuing a central bank-backed digital dollar.

About the steps announced by the Finance Minister on digital currency(Digital Rupee)?

Reserve Bank of India will launch a Digital Rupee by 2022-23. The CBDC will be backed by the blockchain and other technologies. The digital rupee will be the digital form of the physical rupee and will be regulated by the RBI.

The budget announcement was made after consultations with the RBI, and the RBI will decide by when it is ready to launch the digital rupee.

According to the Prime Minister, the digital rupee could be exchanged for cash and will open new opportunities in the fintech sector.

Recently, RBI Deputy Governor has said that the central bank is “working towards a phased implementation strategy” and will examine the CBDCs in the wholesale and retail segments.

Will other digital currencies be allowed in India?

According to the Secretary, Department of Economic Affairs, “digital rupee will be the first and only digital currency in India.” He also explained that the taxation of crypto assets does not legitimize their usage, as crypto-assets do not mean cryptocurrencies alone. According to him, Crypto, in a general sense, is a digital asset that uses crypto technology.

The Budget has used the term “Virtual Digital Assets” (VDAs). VDAs are a superset for all digital assets being transacted on the blockchain, such as cryptos, non-fungible tokens (NFTs), or any other virtual asset.

Note: The draft Cryptocurrency and Regulation of Official Digital Currency Bill, 2021 aims to prohibit all private cryptocurrencies. The Bill also aims to lay down the regulatory framework for the launch of an “official digital currency”.

What are the prerequisites before releasing the Digital Rupee?

First, the design of the currency with regard to how it will be issued, the degree of anonymity it will have, the kind of technology that is to be used, etc., needs to be sorted out.

Second, CBDC would need an entirely new centralized payment system. This system has to be linked to electronic wallets that reside on prepaid cards, smartphones, or other electronic devices.

Third, the government has to develop an interoperable system between the other virtual digital assets (VDAs) and the digital rupee for seamless transfer of funds.

Fourth, digital money will be programmable money. Hence, the government has to come out with suitable products and services using the digital rupee, such as smart contracts.

What are the advantages of announcing a digital rupee or CBDC?

According to the Prime Minister, the Central bank digital currency or the digital rupee will make online payments more secure and risk-free and boost the digital economy in the years to come. He also mentioned that the digital rupee will lead to ease in the development of a global digital payment system.

Further, introducing the digital rupee will revolutionise the fintech sector by creating new opportunities and lessen the burden in handling, printing, logistics management of cash.

Digital Rupee will lead to a whole lot of improvement in terms of digitization of the economy, ease of transfer, not just within the country but across jurisdictions. Further, the Digital rupee will prevent counterfeiting of currency and a boost to the war on black money and corruption.

The Digital Rupee will accelerate financial inclusion, lower costs for financial transactions, especially in the case of cross-border transactions, the advantages of an alternate payments system, the creation of another instrument in the monetary policy arsenal of central banks.

Commercial banks sometimes fail, and depositors lose a big chunk of their money despite the deposit guarantee scheme, but when the money is parked with the central bank there is no risk of default.

CBDC will reduce the need for card networks, payment gateways. There are 1.2 billion mobile phone connections in India right now, but only 582 million bank accounts exist. The CBDC could help to bridge the disconnect.

The other advantages include,

Reducing systemic risk:  There are about 3,000 privately issued cryptocurrencies in the world. According to IMF, the key reason for considering national digital currency is to counter the growth of private forms of digital money.

Industry estimates suggest there are 15 million to 20 million crypto investors in India, with total crypto holdings of around 400 billion rupees (US$5.37 billion). Most cryptocurrency exchanges are asking people to invest and trade in cryptos without providing basic information about the product and the inherent risks.

There is a possibility of these companies going bankrupt without any protection. But the digital rupee has government backing in case of any financial crisis.

Reduce volatility: The national digital currency will be regulated by the RBI. So, there will be less volatility compared to other digital currencies.

Negative interest rate: In tough times, a Central Bank might want people to spend money, hence the concept of negative interest rates. But, presently it can’t do so as people will simply withdraw their money from the banks. CBDCs will solve this problem. A negative interest rate could be easily mandated on CBDCs kept in the wallets.

Complement blockchain-led decentralised finance: All crypto assets’ final returns will be in sovereign currency, and therefore the digital rupee will aid the virtual digital asset(VDA) markets by bridging the gap between fiat money and decentralised finance.

What are the challenges associated with issuing a digital rupee?

Globally, pilot projects on CBDC have been underway since 2014. However, progress is slow because this seemingly simple innovation can have unforeseen consequences. These include,

Challenges to the entire banking system: The impact of the digital rupee on the banking system is not clearly understood e.g., if CBDCs are indeed efficient vehicles for retail savers, this could adversely affect bank deposits. Hence, there might be an impact on the role of banks in credit creation, RBI’s monetary policy, etc.

Further, Sweden’s Riksbank, which launched its e-krona project in 2017, is still studying the need and potential impact of e-krona on Sweden’s economy.

Threat to financial stability: If the RBI offered interest rates on the digital rupee, then it will directly compete with banks. If the regulator ends up competing with the regulated entities, the banking system may see erosion in deposits, threatening the financial sector’s stability.

No incentive to switch to digital rupee for user: From a user’s standpoint, there is no real incentive to switch to a CBDC as a growing proportion of retail transactions are already done digitally or by using UPI-based fast payment systems.

Potential cybersecurity threat: India is already facing many cyber security threats. With the advent of digital currency, cyberattacks might increase and threaten digital theft like the Mt Gox bankruptcy case. 

End of privacy: The digital currency must collect certain basic information of an individual so that the person can prove that he’s the holder of that digital currency. This basic information can be sensitive ones such as the person’s identity, fingerprints etc.

Further, CBDCs will leave a digital trail even with the phone turned off. For instance, trails such as paying for food, fare and lodging.

Operational issues: There will be many operational issues for the implementation of CBDC, including the KYC (know your customer) norms and privacy of data.

What should be done to improve the performance of the digital rupee?

The Government should work towards an interoperable system between the virtual digital asset and the digital rupee. It will unleash opportunities for not only those working or wanting to work in the decentralised finance space (VDAs), but also for traditional finance industry exponents.

Creation of adequate cybersecurity methods: Before the introduction of National Digital currency, the Government has to create certain important things, such as, training of the law enforcement agencies, creating a policy of basic information assessed while issuing, verifying someone’s digital currency.

The RBI needs to create a regulatory sandbox, with limited participants and pre-specified uses, before launching its own digital currency. Only then can the rupee hold its own against other currencies.

Preserving the financial sector stability: The digital rupee can be issued via a distributed ledger, synchronised between the banks and the RBI and not a centralised ledger, held solely by the RBI. This decentralised model will not end up in competition between RBI and other banks.

Though the introduction of a digital rupee provides various advantages for the government, the government has to create necessary safeguards before rolling it out and must bridge the digital divide.