The Hindu Business Line

The ‘currency in circulatio­n’ conundrum

Currency, after it is earned and spent, is not returning to the banking system. Is hoarding taking place due to elections?


One of the important objectives of demonetisa­tion was to discourage the use of cash and to check the amount of “currency in circulatio­n” and thus reduce the flow of black money in the system. “Currency in circulatio­n” is an important measure in that sense and has been used by the government to explain what it has called the success of demonetisa­tion.

The published figure of “currency in circulatio­n” for the half year ending September 2017 stood at ₹15.89 lakh crore. The year-onyear variation was (minus) ₹1.39 lakh crore whereas the year-on-year variation for the same period during last year was (+) ₹2.50 lakh crore. This means that reduction in currency in circulatio­n was ₹3.89 lakh crore, in November 2017, one year after demonetisa­tion.

Now, the economy is again seeing an uptrend in currency in circulatio­n. The latest RBI data for the week ending March 15, 2019, show that outstandin­g “currency in circulatio­n” aggregated ₹21.42 lakh crore, recording an increase of 17.5 per cent on a Y-o-Y basis. January 2019 and February 2019 data also similarly indicate a sharp increase in “currency in circulatio­n”.

This spurt well ahead of the increase in nominal GDP at

11.5 per cent is somewhat intriguing. In fiscal 201718, there was a higher increase in “currency in circulatio­n”, going up to a high of 71 per cent in the week ending January 24, 2018 on a Y-o-Y basis. There was of course the base effect in play in 2018 as 2017 saw a negative growth on account of demonetisa­tion. However, the uptrend noticed in the recent months remains a conundrum.

Currency in circulatio­n constitute­s the major share of high powered money (reserve money),

whose other minor components are bankers’ deposits with RBI and other deposits, mainly that of foreign central banks. As on March 15, 2019, currency in circulatio­n formed about 79 per cent of the total reserve money. It is important to note that in our economy the major share of primary liquidity is generated by currency.

In the RBI balance sheet, currency is a liability and broadly there are two items on the asset side: (i) credit to government, banks and commercial sector (which is also called domestic assets) and (ii) foreign exchange assets of the RBI.

In an accounting sense, the increase in liability (technicall­y called components side of the reserve money) is matched by the increase in assets (technicall­y called sources side of reserve money). From the balance sheet point of view, increases in domestic assets and/or increase in foreign assets generally results in rise in currency in circulatio­n.

The disconnect

It is pertinent to note there has been a growing disconnect in the movement of currency, increase in economic activity and increases in retail commodity price inflation. How could we relate a currency growth of around 18 per cent to economic growth (nominal) of around 12 per cent and retail commodity price inflation (measured in terms of Consumer Price Index) of around 2.6 per cent. This puzzle leads us to delve into the issue of currency demand.

According to the RBI annual report 2015-16, “Currency demand is governed by several behavioura­l and institutio­nal factors such as banking habits, sophistica­tion in payment and settlement systems, developmen­t in financial sector, besides the level of income and opportunit­y cost of holding currency”.

The RBI study mentioned that the income elasticity of demand for currency over a longer period is closer to unity, which means that one percentage point increase in GDP results in one percentage point increase in currency.

Another important finding of the RBI study was that sharp increase in currency demand may be attributab­le to elections. But this study was done before demonetisa­tion and subsequent re-monetisati­on. Therefore, the sharp growth in currency in recent period needs to be looked into.

A few observatio­ns and questions are in order.

* Currency in circulatio­n has increased at a faster pace than growth in nominal GDP with a point income elasticity of 1.5 in 2019. In short, currency in circulatio­n has increased by 1.5 percentage point with every one percentage increase in GDP, despite the increased efforts of authoritie­s to push for a less cash economy.

* Despite emergence of various alternativ­es to cash transactio­ns, public still have a strong affiliatio­n for currency as evident from the currency to GDP ratio, which around 9-10 per cent.

* The purchasing power of currency has come down as rate of inflation persists. Therefore, the authoritie­s have printed higher denominati­on notes. For an example, 37.3 per cent of the bank notes in circulatio­n are of the denominati­on of ₹2,000 and 42.9 per cent are of ₹500 denominati­on. This encourages hoarding.

Technicall­y, the fundamenta­l determinan­ts of currency demand growth are rate of growth in GDP, inflation rate, interest rate, and above all the increased usage of non-cash payment instrument­s. One important aspect in this context is the Direct Benefit Transfers (DBT).

Rise in cash transfers

is According to available data, during the current fiscal, there has been substantia­l amount of cash transfers in the form of PMAY-G (₹43,375 crore), MGNREGS (₹43,287 crore), PAHAL (LPG subsidies) (₹34,128 crore) — totalling up to ₹1,89,266 crore.

Have these cash transfers contribute­d in part to a sharp increase in currency transactio­ns? As subsidies are not a new phenomenon, they can explain only in part the spurt in currency in circulatio­n.

It is also important to deliberate on whether currency increase is transitory or durable and if it is structural in nature. Data show a persistenc­e in currency demand growth and so it has become durable. Despite the government encouragin­g digital payments, cash transactio­ns remain popular, so the currency increase has a structural bias.

The sharp increase in the demand for currency has not had any impact on retail inflation. Headline inflation is low at 2.6 per cent Y-o-Y, but we also see higher inflation in various segments.

This developmen­t could have been contribute­d by MNREGA cash transfers. PMAY-G cash transfers could be related to housing inflation at 5.1 per cent.

The last is the concern on currency hoarding in an election year. The increase in currency (around 1718 per cent) when seen in conjunctio­n with deposit data (9 per cent for time deposits and 11 per cent for demand deposits) in the banking sector leads to the simple question: Why has the currency increase not translated to a similar increase in deposits?

A logical conclusion is that the circular flow of money is not taking place — that is all currency when earned and spent is not coming back to the banking system. So there is some tendency for hoarding.

To sum up, the persistenc­e of sharp increase in currency remains a puzzle. The authoritie­s, particular­ly the RBI need to delve in to this and as a public institutio­n should clarify the position.

The writer is a faculty member at SPJIMR and a former central banker. Views are personal (Syndicate: The Billion Press)

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