Making the transition to a cashless economy

India has one of the highest cash-to-gross-domestic product ratios

It is an iron law of public policy that established players create obstacles to innovations that threaten them. One such response could be building up in the financial system. This newspaper reported on Monday that Indian banks are making it difficult for digital wallets issued by private sector companies to be used on the respective bank websites. It could be restrictions on using bank accounts to refill digital wallets or a lack of access to payment gateways. Regulators will have to take a tough stand against such rent-seeking behaviour by the banks.

Many developed countries such as Sweden are already moving towards a cashless economy on the back on new payments technology. Even developing countries such as Kenya have made immense strides in mobile payments. A drastic reduction in the use of cash has several potential benefits. First, it will attack the problem of black money by leaving behind a transaction trail. Second, there will be greater efficiency in welfare programmes as money is wired directly into the accounts of recipients. Third, there will be efficiency gains as transaction costs across the economy should also come down.

India uses too much cash for transactions. The ratio of cash to gross domestic product is one of the highest in the world—12.42% in 2014, compared with 9.47% in China or 4% in Brazil. The number of currency notes in circulation is also far higher than in other large economies; India had 76.47 billion currency notes in circulation in 2012-13 compared with 34.5 billion in the US. Some studies show that cash dominates even in malls, which are visited by people who are likely to have credit cards, so it is no surprise that cash dominates in other markets as well.

Despite the recent expansion in digital wallet usage as well as the introduction of specialized payments banks, a lot needs to be done before cash is eased out of the Indian economy. One big reason many Indians use cash intensively is that half of them do not have bank accounts, so the success of initiatives such as Jan Dhan accounts linked to Aadhaar data will be very important. A robust payments mechanism to settle digital transactions is also needed, though the National Electronic Funds Transfer and Real Time Gross Settlement services have been a good start. The Reserve Bank of India too will have to come to terms with a few issues, from figuring out what digital payments across borders means for its capital controls to how the new modes of payment affect key monetary variables such as the velocity of money.

The Indian central bank will also have to shed some of its conservatism, part of which is because it has often seen itself as the protector of banking interests rather than overall financial development.

This newspaper has argued on several occasions that India is ripe for a transition to digital payments. The innovations could come from the established banks, but it is equally possible that innovative companies in the private sector drive change. The payments system in any country should be thought of as a network. It will grow rapidly only when network effects kicks in: more people begin to use digital cash in response to more people using digital cash. The result is an exponential growth trajectory. But this can happen only if all users have equal access to the network. That is what the banks seem to be trying to block.

The finance minister mentioned in his February budget speech that India needs to move towards a cashless economy if it is to tackle the scourge of black money. There were subsequent discussions about giving incentives such as a service tax waiver when credit cards or other forms of digital settlements are used. As we have mentioned earlier, a lot of plumbing work also needs to be done. But the regulators also need to keep a sharp eye on any potential restrictive practices that banks may indulge in to maintain their current dominance over the lucrative payments business.