An Analysis of the Binding Constraints on Digital Financial Inclusion in India Using a Decision Tree Methodology Nandini Harihareswara and Howard Miller Abstract The past decade has seen significant innovation and growth in the volume and value of digital payments in India. However, we find that the associated gains have been heavily concentrated in favor of wealthier and urban customers and have had less impact on lower- income and rural populations. While some customers now have a far greater selection of quick, cheap, and convenient digital payments methods, as much as 65 percent of the population remains effectively excluded. Using a decision tree framework, we test a range of factors on the supply and demand sides that could be binding constraints on further digital finance penetration. We find that an unlevel playing field in favor of the (primarily state-owned) banking sector results in a lack of effective competition that could be inhibiting greater innovation and outreach in favor of lower-income and marginalized people. This unlevel playing field is potentially a function of institutional weakness combined with the nexus of control of the government and the banking sector, which is reinforced by the position of the National Center for Global Payments Corporation of India. This control may also be viewed by the government as Development necessary to protect economic stability in a very dynamic market. To the extent that 2055 L Street NW institutional deficiencies are the root cause of regulatory barriers to the entry of new Fifth Floor providers and the scope of digital financial services offered, they are a binding constraint on Washington DC 20036 advancing digital financial inclusion. Under this market structure, the outreach and inherent 202-416-4000 business models of digital payments and transfers do not provide sufficient perceived www.cgdev.org benefits to attract large segments of the population. Further, a lack of trust in providers combines with the perception of low benefits to generate an additional binding constraint, This work is made available preventing the market from reaching a critical mass at which the bulk of the population under the terms of the Creative would have the means and the incentives to use the system. Therefore, the market remains Commons Attribution- at an equilibrium below its potential. NonCommercial 4.0 license. CGD Policy Paper 210 www.cgdev.org April 2021 An Analysis of the Binding Constraints on Digital Financial Inclusion in India Using a Decision Tree Methodology Nandini Harihareswara Howard Miller Nandini Harihareswara is an inclusive digital economies expert and practitioner. She is the author of numerous publications focused on finance, technology, and international development, most recently as coauthor of the G20 paper “Advancing Women’s Digital Financial Inclusion.” She is based in Bengaluru, India. Howard Miller is an independent consultant and researcher focusing on inclusive financial systems. He is based in southern India. Any conclusions or viewpoints expressed are those of the authors, and they may or may not reflect the views of the institutions with which they work. The authors would like to thank Anushree Deb, who provided research assistance through the development of the paper. From the Center for Global Development, Liliana Rojas-Suarez, with support from Alejandro Fiorito Baratas and Diego Castrillon, provided guidance and a critical eye. The paper has benefited from valuable discussions with and feedback from Nachiket Mor, Deepti George and Amulya Neelam (Dvara Research), Pawan Bakhshi (Bill & Melinda Gates Foundation), Leora Klapper (World Bank), and Graham Wright and Akhand Tiwari (MicroSave Consulting). The Center for Global Development is grateful for contributions from the Bill & Melinda Gates Foundation in support of this work. Nandini Harihareswara and Howard Miller. 2021. “An Analysis of the Binding Constraints on Digital Financial Inclusion in India Using a Decision Tree Methodology.” CGD Policy Paper 210. Washington, DC: Center for Global Development. https://www. cgdev.org/publication/analysis-binding-constraints-digital-financial-inclusion-india-using- decision-tree Center for Global Development The Center for Global Development works to reduce global poverty 2055 L Street NW and improve lives through innovative economic research that drives Washington, DC 20036 better policy and practice by the world’s top decision makers. Use and dissemination of this Policy Paper is encouraged; however, reproduced 202.416.4000 copies may not be used for commercial purposes. Further usage is (f) 202.416.4050 permitted under the terms of the Creative Commons License. www.cgdev.org The views expressed in CGD Policy Papers are those of the authors and should not be attributed to the board of directors, funders of the Center for Global Development, or the authors’ respective organizations. Contents Abbreviations ......................................................................................................................................... 1 Foreword ................................................................................................................................................ 3 1. Introduction ....................................................................................................................................... 5 2. Digital payments and transfers in India: Landscape and measurements .................................. 6 2.1. The landscape of digital payments and transfers in India ................................................... 6 2.2. Defining and measuring digital financial inclusion in India ............................................... 9 3. The decision tree methodology.....................................................................................................11 4. The prices of digital payments and transfers in India ...............................................................14 4.1. Cost-to-customer analysis ......................................................................................................20 5. Analysis of the supply side .............................................................................................................26 5.1. Provision of private digital infrastructure ............................................................................26 5.2. Market structure .......................................................................................................................33 5.3. Appropriability of returns ......................................................................................................42 6. Analysis of the demand side ..........................................................................................................47 6.1. Perceived benefits ....................................................................................................................48 6.2. Trust in providers ....................................................................................................................50 6.3. Low incomes ............................................................................................................................54 6.4. Digital and financial capability ...............................................................................................58 6.5. Summary of demand-side analysis ........................................................................................61 7. Conclusion........................................................................................................................................61 7.1. Supply-side binding constraints.............................................................................................61 7.2. Demand-side binding constraints .........................................................................................62 7.3. Interconnected binding constraints ......................................................................................62 7.4. Recommendations ...................................................................................................................63 Appendix 1. The decision tree methodology: Further details .....................................................65 Appendix 2. Further details on costs and prices ............................................................................68 Endnotes ...............................................................................................................................................72 List of Figures Figure 1. Volume and value of selected digital payments options................................................. 8 Figure 2. The decision tree for digital payment and transfer services in India ..........................12 Figure 3. International digital payment comparison: ATM withdrawal fees as a percentage of transaction amount ....................................................................................................17 Figure 4. Charges for sending 1 percent of GNI per capita, PPP, in local currency, as a percentage of transaction amount .............................................................................................18 Figure 5. Trends in expansion of POS devices and digital financial inclusion ..........................29 Figure 6. Frequency of people facing power and network failures, 2018 ..................................30 Figure 7. Levels of financial inclusion among groups who own a phone but have problems, 2018 .....................................................................................................................................31