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India needs to adopt a cautious and informed approach to launching a full-fledged digital currency as the prevalent infrastructure may limit its potential benefits.

Finance minister Nirmala Sitharaman announced a commitment to issue a digital rupee in her Budget speech delivered on February 1, 2022. Although in the subsequent months, the RBI provided only limited clarity on how the digital currency would be developed or rolled out, it still went ahead and launched the pilot of its digital currency.

The pilot was launched in wholesale space (e₹-W) on November 1, 2022, with use of the currency limited to the settlement of secondary market transactions in government securities. This was followed a month later by the launch of the pilot in the retail segment (e₹-R), within a closed user group of customers and merchants.

Sundry other details have been disclosed, such as that the digital currency will be issued in the same denominations as the paper currency and is being distributed through participating banks.

Users can transact through a digital wallet, and transactions can be both person-to-person and person-to-merchant. The digital currency will not earn interest, but it can be seamlessly converted into other forms of money, including bank deposits.

The advantages

India is relatively well-positioned to launch a digital currency: it has put in place an advanced digital payment system that works at scale; a majority of its population owns a cell phone, with a significant number among them owning a smart phone; access to the banking system is widespread, and a growing share of consumers are tech-savvy and proficient in conducting digital transactions.

Yet, the prevalent infrastructure also limits the potential benefits that can be derived from a digital currency.

The main argument in favour of a digital currency is that it is a safer, cheaper, and more convenient mode of payment than cash, cheques, debit cards and credit cards. A second argument is that it will promote wider financial inclusion. Both arguments are in fact dubious.

With the prevalence of a relatively efficient low-cost electronic payments infrastructure, India will reap only limited benefits in terms of convenience and cost. The country has already made unprecedented progress in achieving near- universal financial inclusion, limiting those benefits as well.

A more pertinent rationale in favour of digital currency is that its issuance will allow the central bank and the government to retain control of the payments system in the face of stablecoins and other private payment rails. The concern is that, if payments migrate away from UPI and toward a private-label stablecoin, the central bank will be left with limited insight into the operation of the payments system and limited ability to ensure its integrity. This will especially be the case if a single large private provider acquires dominating market power over payments and related services.

While a valid concern, a more straightforward solution to this problem would be simply to strengthen the regulation of private providers, including stablecoin issuers.

The challenges

Digital currencies may supposedly facilitate cross-border transactions, thereby simplifying things for Indian exporters and importers. But technical obstacles to interoperability and governance obstacles will limit achieving this outcome. Governance problems, in particular, may be formidable. The participating central banks would have to agree on an architecture for the corridor in which one central bank’s digital currency is exchanged for another. They would have to jointly govern its operation. They would have to license and regulate dealers holding inventories of currencies, and ensure that the exchange rate inside the corridor does not diverge significantly from that outside. They would have to agree on who would provide emergency liquidity, against what collateral, in the event of a major order imbalance. In a world of 180 currencies, arrangements of this type would require scores of bilateral agreements.

With so many central banks and governments around the world contemplating the issuance of a digital currency, it was inevitable that India would contemplate the possible development of its own digital currency, as deputy governor, RBI T Rabi Shankar mentioned in an event in April 2022, adding that “it was not a question of whether, but how to do it well.”

But India stills needs to adopt a cautious and informed approach to launching a full-fledged digital currency. It would be advisable to constitute expert groups to analyse the question and place their analyses and recommendations in the public domain. Those expert groups will need to assess the readiness of banks, other financial intermediaries, and the public to use digital currency, its impact on the conduct of monetary policy and its transmission, and implications for capital flows, the exchange rate, and the composition and management of foreign reserves.

In terms of equity, officials and outside experts need to pay close attention to the costs and benefits of a digital currency for population groups with different levels of literacy and differential access to digital hardware and Internet connectivity.

A popular mantra in the digital sphere is “move fast and break things.” In the case of an Indian digital currency, we would instead advise “slow but steady wins the race.”

The likeliest benefit that India will draw from a swap line with the US is the ability to thwart any self-fulfilling speculation against its currency during a sell-off episode. India is unlikely to draw upon the swap line just as it has not drawn upon its existing swap line with Japan. Thus, a swap line with India entails zero commercial risk for the Fed.

India has just weathered with equanimity an emerging market-wide reversal of portfolio flows, lasting from November 2021 to October 2022. The capital outflows occurred due to an unprecedented tightening cycle of monetary policy by the US Federal Reserve, during which it has already raised its policy rates by 450 basis points (bps) after Wednesday’s interest hike by 50 bps, with anticipation of more to come.

India has fared better than many other large emerging markets in the tumult caused by the sell-offs. Yet, the disruptions are evident. At the peak of the reversal, the cumulative portfolio outflows from India were nearly worth $30 billion. The exchange rate with respect to the d ollar had depreciated by 10%, and foreign reserves had declined by 17%.

When the US Sneezes

This ’emerging market sell-off’ episode was not a stand-alone event. A similar exodus of portfolio flows from emerging markets took place in 2013 when Ben Bernanke first announced the intent to start tightening its monetary policy. The phenomenon played out again in 2018, when the US initiated a tightening cycle lasting for more than a year. The event has repeated itself a third time in 2022.

All three episodes bear the following commonalities: (i) The genesis of the sell-offs was due to the tightening of monetary policy by the US. (ii) They were preceded by a period of unprecedented policy easing by the US, resulting in unwarranted and inabsorbable amounts of reversible capital inflows into emerging markets. (iii) When this capital reversed, foreign investors did not discriminate between countries with either sound or shaky fundamentals. The large emerging economies with liquid markets faced a larger brunt as investors found it easier to rebalance out of such countries. (iv) Even if each episode lasted only for a few months, their gravity placed a question mark on the effectiveness and adequacy of the policy toolkit available to the central banks.

Managing these reversals necessitated a delicate balancing act in which the central banks allowed their exchange rate to depreciate gently, simultaneously using forex reserves to avoid large fluctuations in the exchange rate. They postponed expansive fiscal policy measures to reduce pressure on their currencies. They matched the tightening of US monetary policy by tightening their own policies, even if the latter was not amenable to their domestic economic cycles.

RBI has managed these shocks well by effectively deploying the entire policy toolkit. Yet, it could have ostensibly handled the situation with even milder financial and economic disruption if it had access to a swap line with the US Federal Reserve Board.

Swap agreements allow central banks to exchange their currencies with each other. Evidence shows that swap lines with advanced-economy central banks have enabled the emerging markets to better handle the sell-off episodes. The recipient countries can portray larger liquidity in foreign currency beyond the stock of foreign reserves they hold. This signalling helps them ward off speculative pressure on their currencies, even if they eventually choose not to withdraw from such a facility.

Sharing is Caring

The most credible and effective swap line has been the one signed with the US. Countries with access to the US swap line have managed to ride the sell- offs with less volatility, a milder rate of exchange rate depreciation, and a smaller increase in the yields on sovereign debt. The US has provided swap facilities to several advanced economies, but only a few select emerging countries, including Brazil, Mexico, Singapore and South Korea. It has not entertained India’s repeated requests as it has not considered India to be of sufficient economic and strategic importance.

This is a mistaken approach adopted by the US, for India matters to the US and to the world in a number of significant ways: (i) India is the fastest-growing large emerging market in the world. It adds more to global growth, and has a larger bearing for the US growth than do any of the aforementioned emerging markets. (ii) India is home to a considerable amount of investments from the US. So, its economic stability is of considerable economic significance to the US. (iii) India has consistently exhibited macroeconomic prudence. The US ought to make a distinction between a country like India that seeks only temporary liquidity support and other countries that need support due to their long-term unsustainable economic policies or outlooks.

The likeliest benefit that India will draw from a swap line with the US is the ability to thwart any self-fulfilling speculation against its currency during a sell-off episode. India is unlikely to draw upon the swap line just as it has not drawn upon its existing swap line with Japan. Thus, a swap line with India entails zero commercial risk for the Fed.

With sustained economic prudence, when bolstered by the setting up of a swap line with the US Fed, Indian policymakers will need to spend less time and effort in managing the volatility caused by spillovers emanating from US monetary policy. They can, instead, focus on devising policies that would contribute more to global growth and the creation of vital global public goods.