Date : 17/10/2023

Relevance – GS Paper 3 – Indian Economy

Keywords – Money Multiplier, Covid-19, Russia-Ukraine Conflict, CBDC

Context

The testing of the retail segment of the central bank digital currency (CBDC), which started in December last year, is progressing at a slow pace, even though the Reserve Bank of India (RBI) has set an ambitious target of 1 million transactions by the end of this year.

Significance of CBDC:

1. Revolutionizing Cross-Border Transactions:

• CBDCs offer unparalleled advantages in cross-border transactions. Their instant settlement feature makes international payments cheaper, faster, and more secure. Enhanced cross-border payment services can stimulate economic growth, bolster international trade, and promote financial inclusivity on a global scale.

2. Blending Tradition with Innovation:

• CBDCs bridge the gap between digital convenience and the stability of regulated, reserve-backed money circulation. This hybrid approach combines the security features of digital currencies with the familiarity and reliability of traditional banking systems.

3. Promoting Financial Inclusion:

• The widespread adoption of CBDCs could catalyze the transition of the informal economy into the formal sector. By facilitating better tax compliance and regulatory adherence, CBDCs can pave the way for greater financial inclusion, benefiting individuals and economies alike.

4. Controlling Inflation :

• CBDCs possess unique characteristics that can be tailored to exert control over inflation and influence the money multiplier effect. In contrast to conventional fiat currencies, CBDCs are digital and can be subjected to various customisable reserve requirements stipulated by the central bank. One notable requirement under consideration is the imposition of a 100-percent reserve rule, necessitating that commercial banks hold an equivalent amount of CBDCs in reserve for each unit they lend or create as money.

What is Money Multiplier?

The money multiplier signifies the ratio of potential money creation to initial reserves injected into the banking system. It operates within the fractional reserve banking system, where banks are required to hold a fraction of deposits as reserves and can lend out the rest. Loans lead to new deposits, expanding the money supply. The money multiplier depends on the reserve ratio, bank lending willingness, and borrower credit demand, demonstrating the relationship between the monetary base and the economy's money supply.

The formula for the Money Multiplier is:

• Money Multiplier = 1 / Reserve Ratio.

Challenges in Adopting CBDC Across India:

1. Privacy Concerns:

• CBDC adoption raises concerns about user privacy. Central banks, handling vast amounts of transaction data, must strike a delicate balance between transparency and user privacy. Additionally, the compromise of user credentials poses a significant risk in the digital landscape.

2. Disintermediation of Banks:

• CBDC popularity may disrupt traditional banking systems by reducing low-cost deposits. Weaker banks could face challenges in retaining deposits, impacting their ability to provide credit intermediation services.

3. Operational and Security Risks:

• CBDC implementation comes with operational and security risks. The rapid evolution of technology might lead to obsolescence, requiring costly upgrades. Moreover, the central bank must invest significantly in cybersecurity measures to safeguard against cyber threats and ensure data protection.

While the theoretical framework for using CBDCs as a tool for inflation control exists, practical implementation remains untested. Countries like Argentina stand at the forefront of exploring the potential of CBDCs. However, challenges such as regulatory frameworks, technological infrastructure, international collaboration, and public acceptance need to be addressed. Furthermore, the gradual relaxation of reserve requirements after CBDC implementation demands careful consideration, striking a balance between inflation control and encouraging economic growth.

CBDCs: Empowering Central Banks with Real-Time Data:

One of the inherent strengths of CBDCs lies in their ability to provide real-time transaction data to central banks. Traditional methods of data collection for economic analysis often suffer from outdated and incomplete information. CBDCs, by offering real-time and comprehensive transaction data, empower central banks with accurate and timely insights into economic activities. This newfound data granularity can be instrumental in measuring inflation rates, understanding consumer spending patterns, and assessing the impact of policy decisions on the real economy.

Leveraging Reserve Requirements and Controlling Money Supply:

CBDCs possess unique characteristics that can be tailored to exert control over inflation and influence the money multiplier effect. In contrast to conventional fiat currencies, CBDCs are digital and can be subjected to various customisable reserve requirements stipulated by the central bank. One notable requirement under consideration is the imposition of a 100-percent reserve rule, necessitating that commercial banks hold an equivalent amount of CBDCs in reserve for each unit they lend or create as money.

This 100-percent reserve rule carries profound implications for the money multiplier effect. In a fractional-reserve banking system, where banks can re-lend a portion of deposited funds to generate additional money, the money multiplier is typically greater than one. However, by implementing a 100-percent reserve requirement on CBDCs, central banks can effectively curtail the ability of commercial banks to multiply CBDCs, thereby mitigating inflationary pressures on the economy. This strategic move involves reducing the circulation of traditional currency while introducing digital currencies, like CBDCs, thereby shifting the money multiplier from its customary position of more than one to a level of one or close to one.

The Power of Data:

CBDCs provide central banks with a wealth of near real-time information regarding CBDC balances held by financial institutions. This data, coupled with metadata categorizing each CBDC transaction by industry, enables real-time Consumer Price Index (CPI) measurement and more effective inflation management. Central banks no longer need to rely on institutions to report their CBDC assets and liabilities; instead, central bank staff can directly query CBDC balances, ensuring accuracy and reliability in economic analysis.

Way Forward:

1. Collaborative Efforts:

• Central banks should collaborate with financial institutions, technology experts, and other stakeholders in the research, development, and pilot phases of CBDCs. This collaborative approach ensures a comprehensive understanding of challenges and solutions.

2. International Cooperation:

• Given the inherently cross-border nature of payments, international cooperation is paramount. Central banks and financial authorities from different countries should work closely to address regulatory, security, and technical challenges associated with CBDCs.

3. Security and Privacy Focus:

• Prioritizing robust cybersecurity measures is crucial. Protection against hacking and fraud must be ensured. Simultaneously, mechanisms for safeguarding user privacy and data protection should be established, maintained, and continually evaluated.

CBDCs represent a paradigm shift in the global financial landscape. While their potential benefits are vast, careful navigation of challenges, especially those related to privacy, banking systems, and cybersecurity, is essential. With collaborative efforts, international cooperation, and a focus on security and privacy, central banks can successfully usher in a new era of digital transactions, transforming the way the world conducts financial exchanges.

Source – Business Standard