The recent rise of digital currencies, especially Bitcoin, begs the question: what should Pakistan do about them? While digital currencies are currently illegal in the country, many would be surprised to know that in April 2019, the State Bank of Pakistan announced plans to issue their own digital currency by 2025. We should not confuse this announcement with legalization of cryptocurrencies in the country. What is proposed is a launch of a Central Bank Digital Currency (CBDC) aimed at promoting financial inclusion, and reducing corruption and inefficiency. In order to learn more about this topic, we will explore the current state of payments in Pakistan, how digital currencies can solve the identified issues and the design options available to State Bank of Pakistan.
Macro Pakistani has discussed the launch of Raast as the answer to Pakistan’s cash problems. However, Raast will continue to rely on the private sector to leverage public infrastructure to cater to the transaction requirements of Pakistanis. It will build the rails upon which payments will flow. It will continue the practice of past years whereby State Bank of Pakistan has to subsidize cash (by printing it) while the private sector monopolizes the limited digital set up. The cost of printing currency has more than doubled from PKR 6.1 billion in 2014 to PKR 13.3 billion in 2020. While digital transactions in Pakistan are on the rise, over 80% of payments are still paper-based.
While digital transactions in Pakistan are on the rise, over 80% of payments are still paper-based
Note: Paper-based transactions include all Cash Withdrawals/Deposits and Intra-bank payments conducted through Real Time Online Branches
Source: State Bank of Pakistan
Digital transactions in Pakistan are growing over four times faster than paper-based transactions but that does not mean that use of hard cash is falling. Within retail payments, SBP reports E-Banking and paper-based transactions. While most look at the rise of E-Banking as an improvement in the digital payments landscape, it is important to consider what is included there. While E-Banking sounds digital, over 70% of the transactions included are also paper-based. Take for example, cash withdrawals from ATMs. Even though the user is using an electronic channel, the cash withdrawn from the machine goes into the informal economy and becomes as untraceable as any other cash transaction. Similarly, while Real Time Online Branches (RTOB) are by definition online, they include transactions that occur between branches where cash is either deposited, withdrawn or transferred between same bank branches.
Over 70% of E-Banking transactions are also paper-based (cash/cheque dependent)
Source: State Bank of Pakistan
Cash is King
Purely digital transactions through E-Banking are limited to Mobile/Internet Banking, Point of Sale and more recently E-Commerce. While SBP reports only digital E-Commerce transactions, estimates put Cash-On-Delivery as 60% of the market in Pakistan. Cash is truly king in the country. This is true for the financially excluded lower income households, as well as the financially included (with bank accounts) affluent households. A survey by Standard Chartered of emerging affluent Pakistanis showed that 50% of them save money by storing cash at home. In other surveyed countries, the highest ratio was in India where 15% save by storing cash at home. This reflects lack of trust in financial institutions in Pakistan along with the need to avoid coming under the tax net. Additionally, high cost and poor end-user experience in digital services has made cash a natural means of payment and saving.
Majority of emerging affluent Pakistanis save by storing cash at home, due to lack of trust in financial institutions
Source: SCB Emerging Affluent Survey
In order to reduce the reliance on cash in Pakistan but also achieve the financial inclusion goals of the country, an alternative is required. The alternative needs to be as close to cash as possible in order to be widely accepted. Challenges surrounding the country’s large informal economy, low digital penetration and high risk of money laundering and terror financing are well known. What has not helped is the State Bank of Pakistan’s cumbersome regulation and insufficient investment in digital infrastructure in the past. While Raast is a great first step toward digitizing Pakistan’s payment landscape, something more radical is required to tackle the issues highlighted above. One way to incentivize banks to provide better service is to introduce competition from the Central Bank.
The ABCs of CBDCs
Most readers would have heard of Bitcoin and Ripple but Central Bank Digital Currencies (CBDCs) are less popular. A recent tweet on the subject went viral after the US Federal Reserve Chair, Jerome Powell, claimed that the central bank is looking closely at the prospect of issuing a ‘digital dollar’. Remember, SBP announced the same in April 2019 with little fanfare. However, the recent popularity of the subject got Macro Pakistani excited about exploring the topic in more detail. While we will exclude technical details, we hope to break CBDCs down into bite-sized digestible pieces so we can together analyze what their benefit to Pakistan could be.
Currencies can take different forms based on the properties they hold. They can either be ‘Universally Accessible’ like cash is or have limited access like banks do with their reserves and settlement accounts with the State Bank of Pakistan. Currency can either be ‘Central Bank Issued’ like cash or be issued by private entities as is the case with cryptocurrencies like Bitcoin. They can also be ‘Token Based’ like cryptocurrencies, meaning they are on a distributed ledger and anonymous, or they can be based on accounts as our bank deposits are. Lastly, they can be ‘Digital’ as most currencies are today or they can be physical like cash. Most currencies have a mix of these properties as shown by the ‘Money Flower’ below.
Different forms of currencies can be distinguished based on their combinations across 4 key properties
Source: The Money Flower Taxonomy by the Bank for International Settlements (BIS)
Cash issued by the State Bank of Pakistan, is Token-Based (anonymous), Universally Accessible and not Digital. In contrast, Bitcoin is issued by private entities, also Token-Based and Universally Accessible, but is Digital. Ripple, another popular digital cryptocurrency, focuses on wholesale payments (inter-bank settlements and cross-border transactions) and is hence not Universally Accessible, differentiating itself from Bitcoin.
The case for e-Rupiya
In looking for solutions to several identified issues, State Bank of Pakistan will have to think about its intended goal behind issuing a digital e-Rupiya. Pakistan needs an alternative close to cash to improve financial inclusion specifically through formal channels, document real-time picture of economic activity, implement risk-based approach required for Anti-Money Laundering/Terror Financing reforms, reduce share of cash in monetary aggregates and provide retail depositors with safer avenues for saving. That’s a lot to consider.
Since the alternative needs to be close to cash, the e-Rupiya should be Universally Accessible by the average consumer, while being Central Bank issued and Digital. In the graphic above, that excludes the ‘CB wholesale digital token’ that would focus on inter-bank settlements. Given the introduction of Raast should optimize settlements between banks, focus on retail seems like the obvious choice. However, cash is Token-Based and anonymous, which is the core reason behind the informality, money laundering and tax evasion issues. At the same time, the anonymity is what makes cash king in Pakistan. Hence, the key decision that our leaders will have to take is whether they should issue a ‘CB retail digital token’ that is anonymous, or an account based digital currency that is more like a bank deposit.
Macro Pakistani would propose something in the middle, which would solve another problem. A key issue highlighted globally behind issuance of CBDCs is that they would risk financial stability from bank disintermediation. What the ‘CB general purpose account’ represents is the same as what the banks currently hold in reserves with the State Bank of Pakistan. Since the banks currently have the privilege of being the only ones with accounts at the Central bank, handing this privilege to common Pakistanis, would not make them happy. While competition for banks from the Central Bank is good, taking all their deposits away is not. However, if the State Bank of Pakistan puts in place a hybrid model, using the banks to distribute currency through value based digital wallets, it could prevent disintermediation and at the same time have a digital non-anonymous alternative to cash.
Monetary authorities worldwide are piloting digital currencies. However, Pakistan is fortunate in that its ‘iron brother’ is among the leaders on this topic, having launched its pilot for the Digital RMB after 6 years of pre-work. The People’s Bank of China’s main reason for issuing the value based digital wallets was to keep control of the rapidly digitizing economy, under pressure from Bitcoin and Facebook’s Libra. Its pilot involves 4 of the largest state owned banks and 2 Electronic Money Institutions in 4 cities to start with. The wallets do not require bank accounts, which helps with financial inclusion. It is not based on Distributed Ledger Technology (DLT) or cryptocurrency and is controlled by a central entity. It allows for controllable anonymity, which means at the merchant level it is anonymous but the Central Bank can have access to wallets for tracking.
For State Bank of Pakistan, since countering money laundering is a bigger concern than it is for China, it would make sense to have limits on transactions based on the e-Rupiya. At the same time, since lack of savings is a concern, and storing cash at home provides no yield, interest-bearing CBDCs could be issued to incentivize consumers to opt in. The benefits of Central Bank Digital Currencies to the financial ecosystem are significant but they also come with risks. Along with bank disintermediation, they could also end up further marginalizing the unbanked if they do not adopt CBDCs and are not integrated in the digital payments infrastructure. Cyber security issues, privacy and protection risks and potential for the government to appropriate citizen funds also exist.
At the same time, digital currencies can allow for faster and cheaper payments, reduce frictions and costs associated with physical cash storage and encourage formalization of the economy. Macro Pakistani hopes SBP pilots the digital currency soon, to be assess design choices and validate benefits of use cases against the potential risks.