BharatCoin - India's Digital Currency - An Idea whose time has come

This was published in The Economic Times on the 25th of April 2018

Cryptocurrencies have captured the imagination of a section of investors globally. An idea with seductive appeal — cryptocurrencies (like Bitcoins) have gained both fame and notoriety, leading to a global regulatory weariness around them. The latest sceptic is the Reserve Bank of India, which recently banned regulated entities from dealing in cryptocurrencies in India. While commercial, private cryptos struggle with extreme price volatility and regulatory scepticism, there is another interesting concept being developed globally — one of Central Bank Digital Currency (CBDC). In a nutshell, can RBI issue a digital currency, lets call it the BharatCoin, just as it issues currency notes today? It’s an idea whose time has come, and there are some compelling reasons why RBI should consider issuing BharatCoins.

The most important application of BharatCoin would be to provide the general public an expansion in choice for a deposit account – it would be akin to an online-only, sovereign-risk bank account with a modern and cheap payment option. BharatCoin would provide safety of the sovereign like in currency notes (it would be a liability of RBI, in effect the Government of India, rather than a bank), likely provide an interest unlike currency notes today (which are zero interest-bearing instruments, and holders get no return for storing them in their wallets), would be cheaper than most electronic payment solutions today, and have the ability to transact anywhere and with anyone with access to a smartphone. At the same time, for RBI, it would be infinitely cheaper to issue BharatCoin in a digital format than to print, transport, safeguard and carry out forensics on counterfeits on currency notes today. The savings from this exercise would accrue to RBI, and by definition, to the taxpayer.

Second, BharatCoin could make the process of monetary policy transmission lot smoother and efficient. RBI influences monetary policy via changes in what is commonly called “policy rates”— these are rates at which RBI borrows from (or lends to) approved counterparties. However, the list of approved counterparties to RBI is quite small, consisting primarily of licensed banks. Therefore, the transmission of a rate cut (or hike) by RBI to the public (and corporations) at large is dependent on a small set of banks faithfully transmitting the same. For obvious reasons, this is often prone to issues, especially if the small set of counterparties collude with each other to minimise the transmission. It’s an issue that RBI has often raised concerns over. BharatCoin dramatically increases the number of approved counterparties to RBI —essentially anyone holding a BharatCoin is a counterparty — in effect millions of retail and corporates who hold BharatCoin instead of cash or bank deposits. If RBI (say) raises policy rates, and banks refuse to pass on the entire rate hike to depositors, millions of depositors would have an option to en masse swap their deposits for BharatCoins, thereby exerting competitive pressure on banks to follow suit quickly. A more efficient transmission of monetary policy would typically result in better all-round outcomes on economic development, as RBI can sharpen its interventions and minimise collateral impact.

Third, BharatCoin will enable the RBI potentially minimise the cost of government debt. The primary source of revenues for any central bank (including RBI) is issuance of currency notes. For every (say ₹100) note that RBI issues, it holds an equivalent amount of government bond in its balance sheet. As RBI pays no interest on a currency note, it makes the spread between the yield on the government bond it holds and the zero interest rate it pays on the currency note — in technical terms, called seigniorage. Earnings from seigniorage accrues to GOI, which is used for either tax-cuts or spends on various development activities. As the economy starts using less cash at the margin, there is potentially a risk to seigniorage revenues. BharatCoin issuance would be a potential hedge against such a possibility, as issuance of BharatCoins would be similar to that of currency notes, ie, against RBI holdings of government bonds, and accrue seigniorage revenues. In a recent paper on CBDC, Bank of England estimated a 3% boost to GDP on account of interest set-offs to government debt made possible via issuance of CBDC.

Last, but not the least, BharatCoin resolves an old monetary policy conundrum of “zero lower bound”. If RBI needs to reduce policy rates to negative levels in response to a severe slowdown, the existence of cash obstructs the slide below zero. With RBI policy rates at (say) -2% and currency notes yielding 0%, authorised counterparties like banks will convert their reserves with RBI en masse into cash until only the latter remains. At this point RBI would have lost its ability to reduce rates — cash doesn’t pay interest nor can it be penalised — and would no longer be capable of exercising monetary policy. This is the zero-lower bound.

BharatCoin can solve the problem. As it gains more acceptance among the general public in lieu of cash, RBI can cancel high denomination notes. Consequently, in a crisis situation, RBI would have the flexibility of taking policy rates down to negative levels. If authorised counterparties like banks wanted to convert RBI reserves into BharatCoin, the rates on the latter too can be brought down to similar negative levels. Sans high denomination currency notes, the option of converting to cash becomes impractical from a storage/security/warehousing perspective. In a nutshell, it gives greater flexibility to RBI to pursue unconventional monetary policies should the economic situation warrant. Not a situation that India faces in the immediate future, but given the experience of developed economies in the last few years, it provides a template to be prepared!

The flip side? It would be increased competition for banks on their most valuable franchise — retail deposits. Interestyielding BharatCoin would be everything that a bank deposit is, without the credit risk inherent in a bank, and transaction costs that are likely to be a fraction of what banks charge.

BharatCoin will not be a perfect substitute for cash, especially around the privacy features of the latter. However, it is a concept that bears immense promise – of disruption in financial markets and a sharper, better way of administering monetary policy.

New-age DFIs required to fund India's infrastructure

This article appeared in DNA on 15th April, 2018

India is finally grappling seriously with its large non-performing assets (NPA) problem, and the first green shoots of structural changes — recapitalisation, new bankruptcy code, and new NPA recognition norms to resolve the issue — are seemingly visible. While the new institutions, laws and regulations will learn as they are tested, there is a belief that the problem is closer to resolution than ever before in the last four years. However, this is merely rectifying the past.

An equally tricky issue, one that has received somewhat less attention is: What next? How would we fund the next investment cycle which should be taking off in the next year or two? The present NPA crisis was substantially engendered by commercial banks funding infrastructure and other long-term capital expenditure in a big way. It is unlikely that either shareholders, including the government, or the regulator (RBI) would be overly enthusiastic to have commercial banks funding long-term infrastructure again in a big way. Which begs the question, how does India fund its enormous infrastructure needs? Over the last few years, alternate modes of financing — Non-Banking Finance Companies (NBFC), Mutual Funds (MF) and Alternative Investment Funds (AIF) have grown in size and appetite to fund long-term financing requirements. However, structurally MFs and other instruments are largely open-ended vehicles with limited appetite for long-term, illiquid assets. As a result, in terms of size, they are going to be insufficient to bridge the gap that will be left by banks.

In a typically karmic twist, it would seem that the solution would lie in the resurrection of Development Finance Institutions (DFI). Till about 20 years ago, long-term capital requirements of the Indian corporate sector were met by DFIs. The raison d’être of DFI financing long-term debt capital was quite intuitive. DFIs would typically raise long-term financing via attractive tax-free bonds, making it possible to extend long-term loans without running into huge asset-liability mismatch issues. Universal Commercial Banks (UCB), on the other hand, typically raise funding via short-term deposits, and used to have very high statutory liquidity requirements in the forms of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). Consequently, it was quite unviable, both from a pricing as well as from a risk management perspective, for UCB to do large-scale long-term financing.

However, liberalisation changed the landscape completely. With reforms, came in a substantial decrease in CRR and SLR, thereby drastically reducing the cost of funding for UCB. Consequently, the pricing advantage on the cost of funds is reversed, with UCB having a large advantage over DFI. Further, liberalisation of financial markets brought in new instruments (like Interest Rate Swaps, MIFOR, etc) that participants could see developing into effective hedging tools for asset-liability mismatches (long-term loans, short-term, funding via deposits) in the foreseeable future. Liberalisation also brought around an expansion of market participants in the form of mutual funds and private sector insurance companies, both of whom were expected to broaden the market for the new instruments. Soon enough, two of the largest DFIs (ICICI and IDBI) mutated into universal commercial banks, while two others (IFCI and IRBI) withered away.

Unfortunately, as we have seen over the last few years, UCB’s foray into long-term lending has not been a happy experience. Given that most UCBs are funded to a large extent by retail deposits, it has also meant a default sovereign guarantee on the UCB, resulting in taxpayer-funded bailouts. While these are much smaller than the rest of the world, it still raises questions of fairness and accountability.

Ironically, DFIs would be an interesting solution to the problem. They could be primarily funded by wholesale customers through deposits or bonds issued to large corporates and institutions. Ergo, there would be lesser pressure on the government to intervene even if there is a viability issue that develops. Second, being focused on long-term loans, DFIs would develop unique skill-sets in assessing, underwriting and managing their risks. The RBI issued a discussion paper on wholesale and long-term finance banks last year on the viability of a similar construct. It would be tough to revert to the pre-1991 construct of DFI — the world has changed, and Indian markets have also gotten a lot more sophisticated.

The DFI, in its new avatar, could be a hybrid between a western-style investment bank and a traditional UCB. It would not only raise long-term financing to fund long-term assets, it would also be an active market participant in developing the long-term corporate bond market. Contrary to popular notions, India does not have a shallow corporate bond market compared to other peer-group economies in the developing world.

The issue is one of secondary-market liquidity, caused by a dearth of market participants in the space. The new DFI would be an active market-maker in long-term financing structures, as an intermediary as well as a source of intellectual capital. India has been actively scouting for and in some ways successfully attracting foreign investment pools like pension funds and sovereign wealth funds for infrastructure investments. However, given the magnitude of our requirements, foreign investment will always be a small complement to the domestic effort. We need institutions with long-term asset-liability horizons to fund India’s infrastructure, and re-engineered and imagined DFIs are a uniquely suitable option. It’s an idea whose time has come because without an alternative mechanism, India’s long-term financing needs will be hobbled.

“Plus ça change, plus c’est la même chose” — the more things change, the more they remain the same. The old chestnut seems amazingly prescient for India’s banking market!