IIn her 2022 budget speech, Finance Minister Nirmala Sitharaman announced that the Reserve Bank of India is on track to launch one digital rupee by 2023. Coming soon afterRBI Governor Shaktikanta Das clarified that there is no difference between the digital rupee and its physical counterpart, from a money supply perspective.

However, a digital rupee introduces two new features on the demand side of the currency. First, it will give individuals the ability to split their savings and transactions into physical and digital currency. Second, it will increase the speed of these transactions, depending on the extent to which individuals replace physical rupees with digital equivalents.

In both cases, the nature of this divide between physical and digital remains unknown, raising two essential questions. First, what consequences will the unknown nature of this split have on India’s monetary health? Second, what can the RBI do to mitigate the risks associated with this indefinite distribution?

Currency Landscape and the Physical-Digital Split of the Rupee

Consider that you have a physical note of Rs 2000, with which you want to purchase a product that costs Rs 200. But the trader refuses to proceed with the transaction as the return of Rs 1800 does not suit him. Even if the merchant uses a digital payment instrument, the transaction will not be completed if you and the merchant use different digital payment service providers. These examples indicate that acceptability is a prerequisite in a transaction network for making a payment. The next digital rupee will also undergo this acceptability test, suggests September 2021 report of the Bank for International Settlements (BIS).

There are two additional liquidity-related complexities that the digital rupee is likely to face. First, RBI Deputy Governor T. Rabi Sankar pointed to issues of money laundering, terrorist financing, tax evasion, etc. with private cryptocurrencies, in a speech delivered last month. A transaction tracking feature will need to be incorporated into the digital rupee to address these concerns. A recent Ernst and Young investigation suggests that since individuals are concerned about their privacy, such a feature is likely to reduce transactions.

Second, “future utility to users” will be an important factor for citizens to adopt a digital rupee, according to the BIS report. This implies that, compared to the physical rupee or any other monetary instrument, a digital rupee should offer an advantage as a store of value. The most likely scenario is a seamless conversion of the digital rupee into valued assets, which include precious metals, carrier currencies like the dollar, and cryptocurrencies. This will lead to a considerable correlation between the demand for digital rupees and the attractiveness of investors for the appreciated assets.

Therefore, as the RBI builds the architecture of the digital rupee, it must consider the key issues of acceptability in a transaction network and the sensitivity of individuals to transaction tracking.

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Digital rupee in options network

The backward induction method presents a compelling way to think about digital rupee adoption scenarios in the future. Backward induction is the process of reasoning backward in time, from the end of a situation, to determine an optimal sequence of steps.

Consider that there are only three payment instruments – physical rupee, digital payments and digital rupee. Widespread adoption of a digital rupee in the future would mean two things. First, individuals switch from physical rupees and digital payments to a digital rupee to complete their transactions. Second, overall transactions in the economy have increased, with ample traction on the digital rupee.

The first scenario can be ideally situated in the current economic landscape. According to a report published in The footprint in November 2021, digital channels and formal finance made significant inroads in a traditionally cash-dominated economy. So much so that the size of the formal economy grew from around 50% to over 80% between 2017 and 2021, mainly due to an increase in the use of digital payment instruments. Digital payment transactions grew nearly 90% in the three years from FY2019 to FY21, according to a recent report.

At first glance, these statistics suggest that the push for financial inclusion is a positive sign for the adoption of a digital rupee. However, digital payments thrive on associated incentives such as cash back and reward points. Thus, they are likely to retain their basic traction and growth, as a digital rupee will lack similar features. This implies that most transitions will be from a physical rupee to its digital counterpart.

In the second scenario, growth in the overall volume of transactions is plausible with sustained economic growth. The accumulation of this transaction growth in digital rupee, physical rupee and digital payment instruments depends on how individuals prioritize one over the other. The physical rupee ranks ahead of others in terms of anonymity, while digital payment instruments have built-in incentives that are transparent. What incentive will a digital rupee offer? If it floats in the economy as a nominal substitute for a physical rupee, without any additional incentive, people will continue to prioritize the physical rupee and digital transactions over a digital rupee.

Read also : India’s plan to launch a digital rupee needs more thought, less haste

Political leverage

Unless the adoption of the digital rupee has additional incentives over cash and digital payment instruments, its demand is likely to remain weak and volatile. There are also concerns about its use as a store of value, which can gravitate towards popular assets, including cryptocurrencies. As the RBI considers pilot projects before the full-fledged launch of a digital rupee, it needs to focus on four fundamental issues – the extent and volatility of demand for the digital rupee, its store of value attributes, privacy issues and preference for the digital rupee over other payment instruments.

The author is a senior economist at Koan Advisory Group, a technology policy consultancy. He tweets @gautamvikash. Views are personal.

This article is part of ThePrint-Koan Advisory series that analyzes emerging policies, laws and regulations in the Indian tech sector. Read all articles here.

(Edited by Prashant)