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-on-year 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 2017-18, 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 is 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

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 17- 18 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)