Digital illusions

Print edition : March 03, 2017

Credit card transactions still account for a small fraction of business in the country although many establishments, such as this store in Hyderabad, have begun accepting cards following demonetisation. Photo: K.V.S. GIRI

The Watal Committee’s report presents the government with an impossible road map to a cashless nirvana.

MORE than two months after demonetising an overwhelming proportion of the currency in circulation, the Narendra Modi government now appears to have settled on its key objective for setting out on the unprecedented economic adventure. After shifting the goalposts several times—initially it was a means of combating terrorism and fake currency, later it was a war on black money and still later it was to forcibly march the country towards a “cashless” future, which was then modified to a more reasonable “less cash” society—the government now ostensibly has the road map to undertake the hazardous journey to an age when cash will no longer be king.

There is no better and time-tested means for a government bent on carrying out its whims than to appoint a committee headed by a former bureaucrat to give it the report that would justify what it has already decided to do. In August 2016, months before demonetisation, it constituted the Committee on Digital Payments, chaired by Ratan P. Watal, Principal Adviser, NITI Aayog, and former Secretary, Ministry of Finance. The committee dutifully submitted its report in double quick time on December 9, which was approved by the Finance Ministry on December 27.

The haste with which the committee has gone about its business is evident throughout the report. The committee’s slant is also evident in its approach, especially the reverence with which it welcomes the demonetisation move, even though it was commissioned before November 8, and its recourse to suspect data from private industry and multinational companies even when better quality data were available from official sources such as the Reserve Bank of India (RBI). The report’s lack of rigour, especially in tackling the substantive issues pertaining to monetary policy, was also hindered by the fact that not a single economist of worth, not even a specialist in monetary economics, was present in the committee.

Reckless rush

However, to blame the committee alone would be futile. The government, by pursuing an ambitious and reckless push towards “less cash” before setting out a regulatory framework governing digital payments, in effect, placed the cart before the horse.

The report reveals not just the haste with which the Watal Committee has pursued its mission with evangelical zeal but its utter lack of respect for conceptual issues. Nowhere is this more evident than in its recommendation that the regulatory responsibilities for governing the digital payments system be distanced from the RBI. This not only is out of tune with global practices, but it reveals the committee’s sheer inability to understand the fact that although payments account for just a small fraction of what a banking system does, they impinge on modern banking and monetary policy in crucial ways.

In a modern economy, currency creation by the central bank through fiat money is not the only means by which money is created. Deposits with banks, for instance, which provide the base for credit creation, are a means by which banks “create” money. From this perspective, a mobile wallet service provider also acts like a bank; even the users’ monies are held only for a brief period until transactions happen.

Thus, it appears fit and proper that such services are also governed by the central bank. However, the Watal Committee has recommended that they be supervised by an entity that has a measure of independence from the RBI. This suggestion is dangerous because such entities can potentially pose a systemic risk, which is a key responsibility of a central bank. There is also the risk of regulatory capture of the suggested body, the Payments Regulatory Board (PRB), if sections of the payments industry exercise their newly acquired clout.

The committee’s enthusiastic acceptance of the “go cashless” mantra is also evident in the data it has sourced. A good example of how it cherry-picked data is its use of a highly dubious (or at the very least, utterly misplaced) dataset to make the point that India is far too dependent on cash. It points to data sourced from the International Monetary Fund (IMF) and other sources to claim that India’s cash-GDP (gross domestic product) ratio is 12.04 per cent, much higher than countries such as Brazil, Mexico and South Africa.

However, this much-abused dataset, quoted widely by advocates of demonetisation, is an inaccurate measure because it only captures the extent of physical currency in circulation and ignores short-term deposits, which are defined as “broad money”. Logically, these deposits must be included because they are virtually on call by depositors and are, therefore, liquid. Secondly, the fact that such deposits have been increasing as a proportion of the currency in circulation, aided by the spread of banking in India, makes them particularly relevant in the Indian context. The committee, in its bid to justify sending the nation on a cashless path, proceeds to evaluate the “high” costs that cash imposes on the Indian economy. It quotes from McKinsey and Visa, both of which may have a vested interest in India’s mission to go cashless, to drive home the point that going digital would result in huge savings. It quotes McKinsey to claim that “transitioning to an electronic platform for government payments itself could save approximately Rs.100,000 crore annually, with the cost of the transition being estimated at Rs.60,000-70,000 crore” and a Visa report that claims a total investment of Rs.60,000 crore over five years towards creating a digital payments ecosystem could reduce the country’s cost of cash from 1.7 per cent of the GDP to 1.3 per cent.

Even while pushing the benefits of going cashless, the committee does admit that the transition to digital payments “cannot be agnostic to the actual costs incurred by the end customers, the reasons for preferring cash, and the factors inhibiting the uptake of existent channels of digital payments”.

A large part of the Indian economy is its “black” counterpart, estimated at about 60 per cent of the legitimate part of India’s national income. Since a significant portion of the currency in circulation caters to the demand from the shadow economy, apart from the huge segment that is engaged in legitimate but informal economic activity, these estimates miss a significant chunk of the economy and its need for cash. Conceptually, to that extent, they significantly overstate the extent of cash relative to real GDP, including the portion missing from official data.

The naive assumption that digitalised financial transactions are scale-neutral and costless, painless and efficient lies at the heart of the Watal Committee’s report. This has obvious implications for India’s large informal economy, which the Modi government is pushing, under pain of death, towards formality through digital channels. For instance, basic data on the usage of debit cards show how skewed the demand for cards is in India. In August 2016, cash withdrawals at ATMs accounted for 92.28 per cent of the value of all debit card transactions in the country. Thus, less than 8 per cent of the total value was made at point-of-sale (PoS) terminals.

This statistic is a clear indication of a divide that mirrors the income and consumption divide in Indian society. When banks issue cards (debit, credit or any other), card payment system companies such as Mastercard and Visa provide an interface with the customer for which the issuer pays a fee, which is, in any case, recovered from customers. According to a recent study by Visa, the penetration of PoS terminals has slowed down significantly since 2012, when the RBI set limits on what the card companies could charge as merchant discount rate (MDR), the amount charged from sellers. This reveals that card companies may have been slowing down penetration in order to bargain for a bigger slice of the transaction fee. Although the rates apply not just to card-based purchases but to cash withdrawals too (and have been waived or lowered in the wake of demonetisation on a purely temporary basis), there is no guarantee that they will not increase once the situation returns to normal. This is aggravated by the fact that the government may have little or no control, or the will, to prevent banks and card issuers from charging higher rates later. This has been demonstrated in the past with, for example, ATM-based withdrawals, for which customers have to pay a fee after a minimum number of transactions.

The flat fee (as a percentage) is regressive, especially because it punishes smaller sellers. It is in this sense that finance, digital or otherwise, is never scale-neutral. The fact that the immediate victims of demonetisation are small-scale producers and retailers implies that the balance has been tilted against them and in favour of larger producers and retailers after November 8. By skewing the field against small and tiny enterprises, demonetisation has been the vehicle for a massive and unprecedented transfer of incomes and wealth from the poor to the rich.

There is also a fundamental asymmetry in the use of technology in the financial services industry. ATMs, which have been around for decades, were originally touted as a technology that increases efficiency in the use of cash; you only need to withdraw as much as you need, so there is no motive to hoard cash. But that was not the motive for introducing ATMs; the real reason was that they enabled banks to reduce their workforce to cut costs. As ATMs became more ubiquitous, banks started moving from cost cutting to profit-seeking by levying a fee for every transaction above a minimum threshold. In effect, the gains from technology are boosting the profitability of banks while the wider systemic benefits made possible by the same technology have been sacrificed, as the imposition of fees above a minimum threshold actually drives people to hoard cash.

A study by Visa in October 2016, titled Accelerating The Growth of Digital Payments in India: A Five-Year Outlook, reveals that a one percentage point reduction in cash in circulation as percentage of GDP would require digital transactions of personal consumption expenditure to multiply ninefold. In other words, Visa suggested that digital transactions as a percentage of personal consumption expenditure would need to increase from 4 per cent to 36 per cent if the cash-GDP ratio has to reduce from 11 per cent to 10 per cent.

Security concerns

Apart from these weighty economic issues, which are central to the move towards digital financial transactions, there are other critically important issues that the committee has either ignored or swept under the carpet. The question of privacy and security was a central issue at a recent conference on digital payments organised by HasGeek, a platform for software developers, in Bengaluru. Several experts, including some from the payments industry, pointed out the serious security and privacy issues that are being ignored in the rush to go digital. For example, an expert on data security warned that the mindless rush to mobile-based transactions was especially scary because most Android phones are vulnerable because they leak data. In fact, he noted that it may be safer for Android mobile users to perform digital transactions using desktop browsers.

But what is more scary is the manner in which Aadhaar is being touted by the committee as the magic wand by which the digital era can be ushered in quickly. It recommends that mobile number-based and Aadhaar-based “fully interoperable payments” be prioritised within 60 days and that the National Payments Corporation of India (NPCI) be responsible for ensuring this.

There has been significant resistance to the idea of an Aadhaar-enabled service for digital transactions, primarily because of security and privacy concerns. Entities such as the Centre for Internet and Society have warned against linking Aadhaar to the financial inclusion project because it violates the Supreme Court stricture against making Aadhaar mandatory. Kiran Jonnalagadda of HasGeek pointed out that the Aadhaar system offered only “single factor authorisation”. He said in a recent tweet that Aadhaar involved only a permanent login ID without “a changeable password”, which, from a systemic point of view, made it open to abuse.

Longstanding critics of the Aadhaar project have pointed out the launch of such a countrywide programme at a time when a regulatory regime is not even in place, and when India does not have privacy protection laws, is dangerously misplaced. They have pointed to the fact that unlike in the case of a debit or credit card, which can be replaced when its integrity has been compromised, the theft of biometric characteristics of a user implies that they are compromised forever. This is not science fiction but a very real possibility as has been demonstrated across the world.

There are also serious worries that the high failure rate of biometric verification would hurt the poor, supposedly the main target group of the Aadhaar project; the large-scale denial of services such as access to the public distribution system has already been documented across the country. Extending a failed system to real-time financial transactions, thus, appears to be dangerously misplaced. The fundamental issue is this: can a digital mode of payment effectively provide the same level of trust between the transacting parties that is central to a cash-based transaction? The answer to that depends critically on whether the digital mode provides the same level of convenience, cost, predictability and certainty.

The Watal Committee has produced a report that the political masters sought. Its lack of appreciation of the economic issues underpinning financial transactions and of the wider economic processes in the Indian economy are obvious. Effectively, it has delivered what the Modi government asked for—an impossible road map to a cashless nirvana for a people already suffering the effects of demonetisation.

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