Recently, the Governor of the Reserve Bank of India (RBI), Dr. Subbarao emphasized the need to move to electronic payments system in India from its current primarily cash based one. It seems to be a reasonable proposition coming from a central banker especially such transition might mean a better control over an economy with a large informal sector. However, is it economically feasible to have such a transition in India right now? Dr. Subbaroa’s answer is yes and he cites other emerging economies like Brazil that use way less cash than a typical Indian does. But I believe that the nature of payment systems practiced only partly depends on deliberate policies and a whole lot on the economics involved. This is especially true for the retail transactions which was the focus of Subbarao’s statement.
Cash is preferred in many transactions in India as a significant number of people lack access to banking facilities. The RBI has time again pursued various initiatives to spread the banking access, but such efforts have not meant much in terms of transforming retail payments. The way commerce is organized in India (a large number of small sellers- large scale retailing is a new and urban phenomenon) make electronic payment systems prohibitively expensive. Further, use of electronic platforms like Visa or Mastercard for payments subjects the economy to economics of two sided markets. There are many issues involved, and most resolutions suggest a preferred cash used in equilibrium for a country like India (For a review of economics of two sided markets see Rysman 2009. For a non-technical discussion of payment systems in India see Waknis (2010)).
A large informal as well as black economy adds to the necessity of cash use in transactions. Lastly but not the least, the level of economic growth itself is a good determinant of the payment system used. While one could argue that Brazil uses less cash than India and hence the later should follow suit, these countries are not exactly in the same league. To further shed light on such cross country comparisons, one probably needs a careful analysis controlling for country specific characteristics to understand the factors that determine the use of electronic payment systems. In addition, questions like do the existing payments systems evolve to address the frictions in payment system and how do they affect economic efficiency also need to be given thought (See Kahn and Rehbords 2009 for a survey of empirical and theoretical literature on payment economics.).
Cash allows anonymity in transactions and in itself can be looked upon as a solution to anonymity of buyers and sellers. This implies that there will be always some transactions that will use cash. The money search literature pioneered by Lagos and Wright (2005) makes this point very well where money as a store of value gets valued in the centralized Walrasian market because the participants are anonymous. This literature is rich and has handled many issues related to payment systems. For an introduction see Williamson and Wright (2010).
So what could Dr. Subbarao do to make it economically attractive for market participants to use electronic payment systems instead of a cash one? Now that is a question worthwhile some thought!