How would India introduce a national digital currency?

In the annual budget on February 1, Finance Minister Nirmala Sitharaman proposed the introduction of a digital currency to be issued by the Reserve Bank of India (RBI) in the coming financial year.

The introduction of a Central Bank Digital Currency (CBDC) is aimed at giving a boost to the digital economy and providing an alternative to the private virtual currencies that have proliferated in recent times. Work on this ambitious project has been going on for over a year.

Earlier, India was preparing to clamp down on its booming cryptocurrency trade as it felt it could pose serious concerns to macroeconomic and financial stability, and become an avenue for money laundering, fraud and terror financing.

There are an estimated 15 to 20 million crypto investors in India, with total crypto holdings of around 400 billion Indian rupees (€4.68 billion, $5.34 billion).

'Multiple risks' associated

"We are carefully and cautiously examining and progressing ahead as there are multiple risks. The biggest risks are related to cyber security and the possibility of counterfeiting," RBI governor Shaktikanta Das told local media last week, adding that work on both wholesale and retail models of the CBDC was ongoing.

By all estimates, the CBDC will be a legal tender issued by the central bank in digital form, similar to the currency issued in paper and interchangeable with any other currency. The digital currency issued by the RBI would be numbered in units, just like every traditional banknote has a unique number. Only its form is different.

CBDCs would also potentially enable a more real-time and cost-effective globalization of payment systems, according to the central bank.

Experts point out that India will be one of the world's largest economies to introduce the CBDC when it rolls it out later this year. Meanwhile, China has been working on a digital version of its currency since 2014 and is furthest ahead when it comes to launching CBDCs globally, as is Japan.

In January, the US Federal Reserve released a study into a digital dollar, but has yet to take a firm position on whether it would issue one.

"The efficiency of transactions will go up, in the sense that CBDC reduces the cost of transactions including the time costs as the transaction is in real time," Lekha Chakraborty, a professor at the National Institute of Public Finance and Policy, told DW.

Since digital currency can strengthen financial inclusion, Chakraborty believes the digital currency can be an effective prelude if the finance ministry wants to announce targeted cash transfers into the hands of people as part of ongoing economic stimulus programs.

"CBDC can strengthen fiscal and monetary policy coordination. Moreover, it supports financial innovation and strengthens entrepreneurship, especially because it eases cross-border transactions in real-time," added Chakraborty. 

Interest in CBDC has grown in response to changes in payments, finance and technology, as well as the disruption caused by COVID-19.

A 2021 Bank for International Settlements (BIS) survey of central banks found that 86% were actively researching the potential for CBDCs, while 60% were experimenting with the technology and 14% were deploying pilot projects.

"Since it is going to be a digital equivalent of a currency note using blockchain technology, we have to wait for the specifics before it actually becomes reality," economist Indira Rajaraman told DW.

A blockchain is a ledger which keeps track of cryptocurrency transactions, and this ledger of transactions is maintained through computers that are linked across a distributed network.

Transactions in cryptocurrency protocols are combined into blocks, and these blocks are then linked together in a historical record of everything that's happened on that blockchain.

Some of the other reasons for adopting CBDC is that central banks, faced with dwindling usage of paper currency, seek to popularize a more acceptable electronic form of currency.

According to RBI, India's high currency-to-GDP ratio calls for a switch to CBDCs. If large cash transactions can be replaced by CBDCs, the cost of printing, transporting, storing and distributing currency can be reduced.

CBDC for 'financial inclusivity'

"Apart from building a cashless economy, CBDC is also considered an instrument in promoting financial inclusivity and modernizing the current banking sector of India," a senior official in the finance ministry told DW.

Contrastingly, though, there are several possible risks associated with the introduction of CDBCs. They could have prominent geographic restrictions as they are accepted only in the country that issues them.

In the case that retail CBDC accounts are interest bearing, there are clear implications for the banking system. It is also possible that during periods of extreme uncertainty, depositors may choose to migrate away from commercial banks, causing financial upheaval. Also, there is the question of whether CBDCs will offer the same degree of anonymity as cash does.

Some argue that it is therefore critical to design and operate CBDC so that demand for it is controllable compared to bank deposits.

Economists have additionally argued there is no universal case for CBDCs because each economy is different, so central banks should tailor plans to their specific circumstances and needs.

"The challenges are also about issues related to data privacy and trust. As CBDC design is based on anonymity, financial integrity is crucial, as otherwise it could catalyze money laundering and tax evasion. The digital divide in our country needs to be addressed prior to CBDC," said Chakraborty. 

Edited by: Leah Carter