Central Bank Cryptocurrency Currency

Central Bank CryptoCurrency (CBCC):

Digital currency is currently in news.  Russia and China is reported to be on the verge of issuing official cryptocurrency.  CME, the world’s largest exchange, is planning to introduce future on Bitcoin by the end of this year.Here Here  In my last post I have explained why Bitcoin can be considered at best a currency of a community- a virtual country, so to say-  of Bitcoin users. So a future on a foreign exchange of an unknown country without any verifiable foreign  trade activities  is definitely problematic.  Be that as it may; the possibility of introducing digital currency by central banks is now a hot topic. The head of the Secretariat of the Committee on Payments and Market Infrastructure of BIS along with a colleague has recently published a paper on the Central Bank Cryptocurrencies.  In this paper the authors have identified four key properties of Money- issuer (central bank or other); form (electronic or physical); accessibility (universal or limited); and transfer mechanism (centralised or decentralised). It is interesting to see that the authors have failed to identify the most important property of money- unit of account. A medium of payment is not a currency unless it is also a unit of account. That is why  a credit card, a bank debit card or a prepaid cash card  is not money, despite each being a digital medium of payment.   In fact, in terms of volumes as well values, the medium of payments even in a developing country like India is largely electronic. The following table shows that money in India exists mostly in the digital form, as most of the bank money is. Even after exclusion of  time deposit from the ambit of  payment system, the digital money ( bank money)  dominates the physical money or cash.

Composition of Broad Money (M3) in India

Currency with the Public Deposit money of the public Time Deposits with banks
  9.84% 11.15% 79.01%

So issuance of central bank currency would only digitalize the cash component of money as other medium of payments are already in digital form. So  CBCC  should be considered only as a replacement of physical cash issued by a central bank.  The champions of cryptocurrency, however,  would like it to be the sole medium of payments, at least of the online variant. It is difficult to understand why anybody would like to replace a part of the system that is working fine with another only because of its compatibility with a particular ideology about issuance of money.  In fact, instead of reducing the cost, a decentralized transfer mechanism like bitcoin would increase the social cost of running a payment system.  Leaving aside these ideological issues about money for now, let us consider the possibilities of issuing cryptocurrency by a central bank. I intend to outline a protocol that can be adopted in the specific case of India. In this post I enumerate the essential features that a Central Bank Cryptocurrency Currency(CBCC) should possess with specific reference to India.

The Reserve Bank of India (RBI) spent on average 35 billion of rupees in printing notes in last 3 years, ignoring the spike of 2016-17 due to demonetization. This amounts to more than 500 million dollars- not a small sum.  The commercial banks also have to incur huge cost  over and above the printing cost incurred by RBI to manage the last mile of the currency supply chain.  If we can replace printing of notes by creating digital strings of binary numbers in computers, the total cost could be easily reduced significantly.  It is not necessary to eliminate physical cash completely. Digital and physical cash could coexist for a long time to come. When every citizen is connected to the digital space we can think of complete elimination of physical form of cash.

Let us first understand how the paper currency system works in India. Before that, we need to consider the enormity of logistics involved in cash management system in a country like India. As on end March 2016, 90 billion pieces of notes and 89 billion pieces of coins were in circulation in India. The number of currency chests and coin depot/sub-depot were 4211 and 4008 respectively at the end of 2012. There were around 222 thousand ATMs in India. The details of the currency supply chain is given below.

  1. Note printing presses print notes as per indents placed by Currency Management department of RBI.One characteristic of the paper note is worth noting here; every note has a distinct identity.
  2. RBI receives the currencies in their vaults
  3. RBI remits the currencies so received to various currency chests maintained at bank branches.
  4. The commercial banks run the currency chests as an agent of RBI, while the treasure in it is the property of RBI. Any withdrawal or deposit into the currency chest is recorded as debit or credit respectively in the bank’s account maintained with RBI.
  5. Transport of currencies from currency chests to other bank branches  is the responsibility of banks.
  6. General public can obtain cash from banks either over the counter of bank branches or from ATMs. Government departments having accounts with RBI  withdraw cash from RBI counters to meet their cash needs, and thereby inject cash into the economy.
  7. When general public or government departments deposit cash into their bank accounts, the banks or RBI examine the circulation worthiness of deposited notes. The soiled notes are then withdrawn from circulation and briquetted by RBI.

We are interested in designing a supply chain that delivers digital currency to general public, maintaining the basic functionality and integrity of the existing supply chain.  We need not differentiate between notes and coins in the digital environment. .

The main characteristics of the proposed CBCC would be as follows:

  1. Each note would have specific denomination- large denomination of 5000 and 10000 can also be introduced.
  2. If Alice wants to pay 102 rupees to Bob and Alice has only one 100 rupees and one ten rupees in her wallet, the system would function exactly the way cash based transaction would function. Alice would pay one 100 and one ten rupees to bob. Bob would immediately pay back to eight rupees to Alice in denominations available to Bob.
  3. Like Bitcoin there would be wallets as app in mobile or users can use hardware based wallet also. There is no question of having any exchange as custodian of wallet in dematerialized form.
  4. A person without a bank account can download a wallet and can receive digital currency in this wallet.
  5. There would be no connection with a wallet with wallet holder’s bank account. However, a wallet holder would be able to download cash from her bank account as currently she withdraws cash from her bank account. The only difference would be that the bank / ATM would give her digital cash and not physical cash
  6. There would be no special KYC verification for downloading digital wallet apart from providing a unique identification number.
  7. In case of loss of a wallet, the process would be the same as it happens if one losses one’s physical wallet containing physical cash. A First Information Report (FIR) has to be registered with a police station and the system would ensure that missing digital notes are blocked to the extent the digital money in the lost wallet has not been spent till that time. After completion of investigation the cash can be restored to the original owner.
  8. The central bank may prescribe a limit to the value of digital currency a wallet can hold. For example, it may be stipulated that the wallet is designed to hold a maximum amount of 100 K rupees. A wallet holder would not be able to load cash to her wallet from a bank or from another payer more than amount.
  9. It may be possible to take insurance for loss of a wallet with a sum insured to the extent of a pre-determined fraction of the amount lost. The wallet holder has to pay the insurance premium.
  10. It would be issued by the central bank as it is done today.
  11. It would retain the anonymity of cash to a large extent- but theoretically for a given transaction payer and recipient’s identity can be found out.
  12. There would be almost instant authentication of any transaction without any third party verification. The central bank would take the responsibility of authentication without any manual intervention. The process would be almost instantaneous as it happened in the use of debit card today.
  13. It would run parallel to paper currency till such time the share of paper currency becomes negligible
  14. It would be a legal tender with the rider that if the recipient of a transaction is not ready to accept digital currency, the payer has to pay the former with paper currency.
  15. All government agencies would have the infrastructure to receive digital currency. No government agency or a public utility would not be able to deny any digital currency transaction if the counterparty insists on that form of transaction. Thus a citizen would be able to buy a bus or metro ticket with digital currency. Taxes also can be paid by digital currency.
  16. A bank account holder can go to a bank branch or an ATM and would be able to load digital currency in her wallet as if physical cash is being dispensed as it happens today.
  17. With the consent of its employees, an employer can pay wages or salaries in the form of digital currencies. Government would prefer to give subsidies through digital currencies.
  18. Digital currencies would not work outside the jurisdiction of the issuing central bank. Thus it is a legal tender within the country of issuing central bank.
  19. A foreign citizen can exchange foreign currency with digital currency as long as he or she gets the wallet downloaded from the issuing central bank’s portal. The only restriction is that if the wallet is used for transaction outside the issuing central bank’s jurisdiction, it would not be authenticated. A money changer can exchange foreign currency (paper form) with domestic digital currency.
  20. No transaction fee is to be paid for using digital currency
  21. The central bank would be free to issue digital currency of any amount as it happens today.

Is it possible to have CBCC with all the above features? Surely it is possible using the same technology that Bitcoin uses, with some tweaking. In my next post I will outline a high level   design of such a system. I am confident that it should be possible to develop such a system which would not allow double spending and provide a very high level of anonymity to transactors and their transactions.


Other references: here here

Bitcoin- Comment on Aswath Damodaran’s Post

Prof Aswath Damodaran (AD, henceforth) is a well-known name in the field of corporate finance and valuation of financial products. It is unfortunate that despite his formidable reputation in valuation of financial products, his latest “Musing on market” is a complete let down (You can read complete post here). He starts the blog by classifying investment assets into four categories. These are: Cash generating assets, Commodity, Currency and Collectibles. The first three categories do not need any clarification. But what about Collectibles? Picasso’s paintings fall into this category because they do not generate cash and, therefore, cannot be valued but it has a price. So, according to AD, something may have price but no value. For him “value” is synonymous with discounted future cash flow that an asset generates. So if an asset does not generate future cash flow, then it has no computable “present value” or “value”.  This definition of value is a highly myopic interpretation of notion of “value” that has been debated from the time of Adam smith to Gerard Debreu. This apparent distinction between price and value leads him to differentiate between trading and investing. The only difference between a trader and an investor is that they make different intertemporal choices.  An investor in collectibles has a choice to sell it immediately or sometimes in future. It follows logically that he finds that it is worthwhile to wait to get a higher price in future. Or he may get more pleasure holding it for a long time to come. The DCF valuation that financial instruments are subjected to, can be looked upon an estimate of the future market price. That is why; there is a market of financial instruments. If DCF is a correct estimate of “value” of any financial instrument then there is no reason why every dealer of a treasury would not have the same opinion about the intrinsic value of that instrument. If every trader has the same opinion would the market exist? According to him, traders do not bother about value but they only concerned about price. This begs the question – how price is determined in financial market?

Although we are really not concerned about the distinction between value and price, the issue becomes relevant in the context of Bitcoin- the subject matter of AD’s blog. Per force, AD has to categorize Bitcoin per his own classification scheme. Bitcoin does not generate cash; it is not a commodity too. So we are left with only two categories for Bitcoin to be slotted. AD now considers the definitional attributes of a currency.   These are well accepted and standard- unit of account, medium of exchange and store of value. Surprisingly AD finds that Bitcoin satisfies all the criteria to be designated as currency.  According to AD, anything which is fungible, divisible and countable can qualify to be a candidate “unit of account”.  If this is true, then theoretically any currency in any jurisdiction can function as currency. In fact, in some African countries, many small shops quote their merchandise in USD terms. But their balance sheets have to be prepared in terms of domestic currencies as per the law of the country. The acid test of anything to qualify as currency is that whether one can pay tax with that thing or not. AD gives three reasons for Bitcoin’s failure to take off as the preferred currency for majority of people. These are: – inertia, price volatility and competing crypto currency. He fails to note the most important reason- no sovereign backing. We have heard of dollarization of many domestic currencies because of people’s lack of trust on the domestic sovereign’s ability to preserve the purchasing power of that currency. But we must note that in no case people of such country start using the neighboring country’s currency, which could be as inflation prone as the former. In other words, backing of a powerful and trustworthy sovereign engenders the trust that is required for something to function of currency. The properties “medium of exchange “and the “store of value” neither jointly nor severally can make anything – real or virtual- a unit of account.

The problem with the ongoing effort to declare Bitcoin as currency is rooted in this historically untenable proposition that money originated from the act of barter. There is enough anthropological and numismatic evidence to the contrary. The renowned numismatist P. Grierson gave the simplest definition of money – ‘all money that is not coin or, like modern paper money, a derivative of coin’.  Historically, coins were always associated with an issuing authority. Thus sovereign backing is a prerequisite for something to become money in a specific jurisdiction.

So Bitcoin is not a currency or money proper. Of course, we can argue that the community of Bitcoin coin users can be considered as forming a “jurisdiction”. The “Bitcoin” is a currency of that virtual jurisdiction. But then Bitcoin can be considered as a currency of only that country. Then, the population size of that country would be smaller than Democratic Republic of São Tomé and Príncipe (200K) of West Africa.  The currency of that country, Dobra, suffered so much depreciation that the government had to issue a new Dobra in exchange of 1000 earlier Dobra. No foreign exchange trader has ever considered Dobra as a tradeable instrument. Bitcoin is experiencing appreciation of similar magnitude and, therefore, people are considering it as a lucrative financial asset. But to consider Bitcoin as a tradeable instrument would be blasphemous in the rarefied group of forex traders. AD, of course, suggests exactly the same in regard to Bitcoin.

It might be fashionable to hold an extreme libertarian view in the current dispensation of USA. In that environment, as the then Citigroup Chief Chuck Prince told in an interview, just when sub-prime crisis was knocking at the door of wall Street – “when the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing”. This was on July 10, 2007. On October 5, Merrill Lynch announced a US$5.5 billion loss, revised it to $8.4 billion on October 24. We hope that gullible investors awash with liquidity do understand that music is bound to stop sometime and who knows who would be standing without a chair then.


Does Political Business Cycle exist in India?

(This is an extended abstract of my paper with the above title)

See the full paper at


There exists a vast literature inquiring and modelling the nexus between politics and macroeconomic policy making. Mostly the western democracies have been the focus of empirical investigations on this subject, stirred by publication of the paper (Nordhaus1975) by William Nordhaus. This is not surprising as these countries have long history of regular elections based on two party system. Democracies in most of the developing counties are of post second wold war vintage and nominal in nature. In many such countries elections only provide a façade for perpetuating one party rule. India provides a unique case of a large democracy with multiple parties with more or less stable electoral process and peaceful transfer of power from one party to another. This gives an opportunity to examine how important macroeconomic variables are affected by the compulsion of electoral process and partisan ideologies in a developing country afflicted with persistence poverty and a large informal economy.

Most of the empirical studies based on data of OECD countries have found that electoral and partisan motives have a greater short term impact on inflation than on real variables like output growth or rate of unemployment. Recent studies based panel data on OECD countries have reinforced these findings.

The present study is an empirical attempt to explore the nature of this nexus in case of independent  India using 62 years of monthly data on inflation supplemented with data on election and ideological stand of political parties in power. Real variables have been kept out of the purview of this paper because of lack of long term low frequency data (at least quarterly) on output. The coverage of monthly index of industrial production is limited to formal sector and workers in organized sector constitute a small minority of voters.

Studies on inflation in India have pointed out that both structural factors and monetary factors are important determinants of inflation in a country like India where rain fed agriculture is still important and imported oil is a major source of demand for foreign exchange. Thus internal shocks precipitated by weather induced failure in agricultural sector and external shocks arising out of spurt in oil price need to be factored out to identify the impact of electoral motives and partisan ideology on Indian inflation dynamics. Subject to availability of relevant data, the paper has attempted to carry out such analysis for a truncated period.

The present analysis also takes into account the fact that there is an important structural break in Indian electoral politics since 1977. Before that there was a one party rule in the centre, although the break in states had come in 1967. After 1977, India has seen rule by coalition of parties as well as single party rules. When a coalition is led by a national party playing the dominant role, we have taken that coalition as a single party rule. Like USA, the congress party is considered as left leaning party and Bharatyia Janata party (BJP) as a right wing party.

This is because, the Congress party has shown a revealed preference for India’s large public sector, while BJP always championed the cause of traders and private sector.  The coalition governments were formed by regional parties who championed the cause of socially backward castes and religious minorities. A priori, it is expected that they would follow a left leaning policy. Thus, instead of two party political system, the Indian polity can be termed as consisting of three political

formations. Prevalence of large scale absolute poverty and rural population comprising the majority of voters, every political formations have to woo the poor and marginal people to win elections. So, on a priori basis, we should expect little difference in behaviour of political formations with regard to fiscal and monetary policy stances in periods leading to and after elections.

There is another dimension to policies that impact inflation. This is the presence of a central bank which is known to be one the most professionally run central bank of developing counties. One interesting fact about the Reserve bank of India is that many of its governors were career civil servants. These bureaucrats are members of the elite federal government service known as Indian Administrative Service (IAS). After spending the best part of their career in various government departments, they cannot be expected to differ radically from polices they were associated with in their whole career. So their view about factors that cause inflation would resonate better with politicians than the economists who may have better understanding of the monetary dimension of inflation. So in this analysis a binary variable (civil servant / economist) is used to capture the central bank’s willingness to accommodate an expansive fiscal policy.

The canvas for this empirical exercise is now laid down. The target variables are two measures of inflation- a wholesale price index (WPI) and a consumer price index (CPI). WPI can be considered as a proxy for producer price index while CPI is based on the consumption basket of industrial workers- not the entire working population. Till recently, our policy makers – both in federal government and in RBI- used WPI as the official measure of inflation. For capturing the structural factors impacting WPI two components of WPI- food price and oil price indices- are considered. For election variable, eight months prior to an election is taken as the period of expansive fiscal policy and eight months after the start of the fiscal year following the election as the period of putting a break on the expansionary policy.. The later part of the election variable has been constructed to reflect the process of policy making in India. In India, the central government budget is the mechanism through which government formulates its fiscal policy. So even if a political party comes to power in the middle of a fiscal year, it generally waits till the start of the next fiscal year to roll out its fiscal policy. Any intermediate intervention is not expected to have any major change in already budgeted incomes and expenditures.

The empirical exercise is based two statistical procedures. These are regression based procedures and Anova based procedures. The regression based procedures takes into account the autoregressive nature of the target variables. Original variable as well as residuals from auto regression are used as dependent variable.   It needs to be pointed out that inflation variable is found stationary process in India. As regards Anova based exercises, the GLM procedure is to take into account the unbalanced nature of the implied factorial design of the exercise.


The results are quite interesting. These are:

Results for WPI

  1. For the entire period (1954 to 2016), RBI governor dummy is the only explanatory variable that comes out significant along with food inflation (oil inflation data not available for entire period).The lagged dependent variables are included in the regression but not considered as explanatory variable. Election variable is not significant for any combination of explanatory variables. This result remains same whether residual from autoregressive equation or original variable (WPI) is used.
  2. For the truncated period (January 1977 to August 2016), even food inflation shows no explanatory power. Only RBI Governor dummy comes out as significant.
  3. Indian economic reform was initiated in July 1991. Using data from the next financial year, regressions have been run for WPI inflation using many other variables for which time series data are available. These are central bank’s credit to government and growth in money supply and oil inflation. Using these variables, it should be possible to identify whether after accounting for these variables, one can detect any explanatory power for factors like Election and RBI Governor. The resulting regression shows that Election dummy does not appear to have any explanatory power for inflation. If the WPI inflation is regressed on other explanatory variables and the residual from that regression is regressed on the variables of our interest, then only Election variable appears to have no significance. Both Party and RBI Governor Dummies are found to be significant at 5% level.
  4. The Anova exercise based on appropriate Sum of Squares shows that mean inflation varies significantly with regard to RBI Governor factor and not with regard to Party factor. Result is much stronger when the truncated period from 1977 is used. However, when Party and Election are taken as influencing factor, mean election for the whole period differs significantly with regards to the Party factor and not according to the Election factor. After 1977, however, mean inflation differs significantly across both the factors, namely Election and Party.


Results for CPI

  1. As regards CPI data is available from 1969 to 2016. For the whole period the results are similar to the ones reported above with one exception. If food inflation is not included as explanatory variable, Election variable turns out to be significant. But if both food inflation and Election variables are used, only food inflation shows a significant impact on CPI. However, RBI Governor dummy always appears as a significant factor.
  2. For the truncated period (January 1977 to August 2016), Election variable comes out significant in different combinations of explanatory variables.

Concluding Observations:

Two important conclusions emerge from the entire exercise.

  1. For a developing country like India, where the electoral process is well established, all political parties perforce have to follow policies that appeal to majority of voters. The burden of managing inflation more depends on the views of central bank governors to management of inflation. When civil servants are governors, the possibility of central bank accommodating fiscal profligacy of the politicians are relatively more as compared to the case when professional economists are in the helm of the central bank.
  2. With the end of one party dominance, the electoral motives appear to be slowly emerging although results are weak. As CPI starts becoming the inflation variable to be tracked by policy makers, the present exercise indicates that there is a distinct possibility that electoral motives would come into play in engendering a Political Business Cycles in India also.




Digital Currency- Hype or Future

This is an abstract of the talk that I gave to students of IIM , Indore on 5th October.

The ability of central banks to maintain the value of fiat money came under a cloud in the wake of the financial crisis that hit the developed economies in 2007/08. A libertarian view about privately issued money that always remained in the fringe of mainstream view of money started gaining currency. The computer geeks who hate any centralized authority started toying with the idea of digital currency that could have all the properties of physical cash and could be used as an efficient medium of exchange of values but without the backing of any central authority. A number of attempts to introduce a digital currency backed by cryptography were made before the dominant digital currency of today- Bitcoin- came into existence. Notable amongst them was Digicash invented by David Chaum in 1990. The experiment failed miserably and the eponymous company filed for bankruptcy in 1998.

In October 2008, an unknown programmer, or a group of programmers, under the name Satoshi Nakamoto published a paper titled Bitcoin on a cryptography mailing list and released as open-source software in 2009. The most critical issue that Bitcoin protocol successfully addressed is the problem of double-spending.

The technology as well as philosophy underlying the Bitcoin system traces its root to 3 different disciplines.

Firstly, it is meditated through a particular view of money- money being primarily a medium of exchange. From a monetary perspective, this aspect of Bitcoin makes it a trustworthy and relatively cheap decentralized payment system without any centralized settlement mechanism.

Secondly, it intelligently adapts certain well known features of distributed computing and information systems. Any distributed system has to resolve the problem coordination so that all the system can continue to function as  expected even if one or more nodes fail or start behaving arbitrarily. This issue is also looked upon from another perspective which is known as “state replication”.  A related problem germane to any distributed computing and information system is the Byzantine problem. The problem statement is- how to arrive at a consensus about an input value vi started by a node i, when a maximum of   f nodes have crashed. The proof-of-work mechanism has also originated in the distributed computation and information management area. This mechanism has also been made an integral part of Bitcoin protocol for validation and authenticity of transactions in Bitcoin network

The last and the most important building block of Bitcoin are the methods and tools of Cryptography. At the heart of Bitcoin lies one way function, hashing function, modulo arithmetic, public-private key, digital signature and maintenance of a public ledger of all validated transactions.

This talk would introduce all the building blocks of Bitcoin in a largely non-technical way. It would also highlight the potential fault lines of Bitcoin and why such a technology cannot become a currency proper. The presenter would argue that Central Bank Digital Currency based on the underlying technology of Bitcoin is very much possible. This is the most desirable and probably inevitable future of paper currency