Handle with care

Address risks before introducing CBDC

Aside from steering the monetary policy operations in a complex macroeconomic environment over the next fiscal year, the Reserve Bank of India (RBI) will be expected to undertake another challenging assignment. In her Budget speech, Union Finance Minister Nirmala Sitharaman had proposed the “digital rupee”, starting 2022-23, and the RBI would issue it, using blockchain and other technologies. The government believes the central bank digital currency (CBDC) will give a boost to the digital economy. While there is merit in the argument, there are a number of issues, including those related to the so-called cryptocurrencies or digital assets, which need to be addressed.

The government informed Parliament this week the mining cost of cryptocurrencies or digital assets would not be allowed as deduction under the I-T Act. The government has imposed tax on gains from cryptocurrencies and will soon come up with a definition of virtual digital assets. It has been reported the government is considering imposing goods and services tax on the entire value of such transactions. The government needs clarity in terms of how it intends to treat these new-age digital instruments. Theoretically, excessive taxation could push the entire market underground, which would not help anyone.

Similarly, the issue of the CBDC should be approached carefully because even minor errors on this account could potentially put financial stability at risk. There are various reasons driving central banks to study the possibility of launching CBDCs. According to a 2021 Bank for International Settlements survey, over 80 cent of central banks were actively studying the potential. The use of cash in many countries has declined over time and central banks are contemplating issuing digital currencies that would potentially make transactions more efficient. The adoption of digital transactions also increased significantly after the outbreak of the pandemic. Advanced economies were driven by the fact that CBDCs could make monetary policy more effective. It could help, for instance, in enforcing negative interest rates. But with the surge in inflation rates globally, this may not be relevant for now. But the biggest reason perhaps is the fear of the adoption of private virtual currencies, which could result in authorities losing monetary control.

Central banks would need to design CBDCs in a manner that doesn’t threaten the banking and financial system. For instance, if CBDC accounts are opened with the central bank, they could undermine the banking system. If deposits move away from banks considerably, they will have to reduce lending, which would affect the productive sectors of the economy. Also, if banks lose low-cost deposits, lending rates in the economy will go up. In fact, things could worsen for the banking system at the moment of weakness. Depositors could shift funds from weak lenders to their digital currency accounts, which would lead to a run on the banks. The operating framework for the CBDC, thus, would be extremely important. For instance, where will the digital rupee be stored, can such an account be interest-bearing, who can hold how much, and how quickly can the CBDC be converted to normal rupee bank deposits? There are a number of such issues, including those related to technology and privacy, which will need to be addressed. There is no need to rush. Possible plans should be first made public so that they can be widely debated before implementation.