The paradox of high cash intensity

The high cash intensity of the economy since early 2000s, its acceleration in the last two or three years and its peaking during FY 2021 are counter-intuitive developments. They are not ideally aligned with RBI’s currency demand forecasting models.

The decadal average ratio of currency with public (CwP) to GDP steadily increased from 8.2 per cent in 1980s to 10.6 per cent during FY2010s. (Data on currency with public has been sourced from the RBI’s Weekly Statistical Supplement and Handbook of Statistics on Indian Economy.) Paradoxically, it reached a high of 14.5 per cent in FY2021 despite large decline in GDP and multi-fold increase in digital payments. Continuation of this high ratio at 13 per cent (₹29 lakh crore as per the last week of February was the currency in circulation) during FY2022, despite month-on-month jump in e-payments, remains a puzzle.

There has been a persistent rise in cash intensity over the last three decades. The decadal average share of currency in households’ financial assets increased from 8.8 per cent in 1990s to 9.8 per cent in 2000s and further, to 12.4 per cent in 2010s (Table).

This is not explained by the currency demand models nor by transient events like elections, festivals or precautionary holding by public. CwP to demand deposits ratio reached record high during 2010s. The CAGR of CwP and nominal GDP were 13.4 per cent and 12.2 per cent, respectively, over FY2000-20 period. (CAGR calculations are by the writer.) What else explains this attachment to cash, despite digitisation?

Missing variables

In Fisher’s MV=PT equation, the transaction demand for money [M] consists of currency, demand deposits and trade credit [TC]. It seems, systemic developments in TC are not considered in the monetary models. The second missing variable is the need for cash to finance under-invoiced/illegal portion of imports from China which appear to have steadily surged, since early 2000s. These two ‘missing variables’ distort projections relating to demand for money, its velocity and liquidity conditions -- the key elements of RBI’s monetary management.

Under-invoiced Chinese imports

Large cash is required to finance steady and massive growth in under-invoiced/mis-invoiced/illicit Chinese’ imports. This has also led to the growing demand for high value notes. The CAGR of these notes was about 20 per cent, much higher than the growth of nominal GDP over the FY2001-21 period. Oddly enough, there has been a sharp rise in the share of high value notes to the pre-demonetisation level. These import appear to be too massive to nullify decline in currency demand due to financial deepening and spurt in digital payments.

Some research studies estimate the enormity of such imports from China to India and other developing countries. CAGR of official imports from China was 25 per cent over FY2000-20. In absence of data on covert imports and given the fact of our consumption and industrial structure being overdependent on Chinese import, we can assume that covert imports grew at perhaps the same rate as growth in value of official imports. This direct relation between official (or for that matter covert) imports and currency growth is depicted in the graph. Interestingly, Chinese imports increased 49 per cent between January and November 2021, despite lower private consumption, low capacity utilisation and strained ties with China. This perhaps explains the continuation of high cash intensity in FY2022.

Dysfunctional trade credit

Demonetisation resulted in formalisation (conversion of notes into bank deposits) of high denomination notes accounting about 87 per cent of total value of currency in circulation. However, post-demonetisation saw accelerated growth in CwP. CwP/GDP ratio in FY 2020 reached FY 2016 level.

Accelerated currency growth since FY 2018 is also attributable to economic uncertainty arising from demonetisation, GST and the first and second waves of Covid. Both buyers and sellers face liquidity and credit risks. Firms increase cash/bank balances by curtailing receivables and preferring cash sales to credit sales. Repayment behaviour, credit risk, B2B trust and liquidity conditions in the TC ecosystem dramatically changed.

The sudden stop in circulation of high denomination notes severely impacted currency velocity. It triggered liquidity crisis-led payment delays and defaults across businesses. Subsequently, teething issues in GST led to loss of flexibility in use of both informal and formal business funds in financing B2B transactions and inertia on the part of traditional businesses to migrate to a new tax system. This reinforced disruptions in TC and its repayment flows.

Just as this had begun to stabilise, the first and second waves of Covid struck business operations and inter-firm credit and repayment flows. The first wave not only impacted the ability of many to repay but more worryingly, resulted in evaporation of willingness to pay. The second wave amplified and accentuated these behavioural changes. This cascaded into a lengthening of the average repayment period, large scale defaults, receivable backlogs and bad debts in the TC network.

Negative TC conditions spur a strong preference for cash sales and reduce currency and TC velocity. These amplify cash holdings by firms.

The RBI’s Financial Stability Report of July 2021 shows a steady increase in cash holdings by a sample of 1,360 listed private non-financial companies. The cash to total assets ratio of these companies steadily increased from 3.9 per cent in H1FY2020 to 5.3 per cent in H2FY2021. An analysis of 1290 BSE listed manufacturing companies based on Prowess, CMIE database, shows that both cash and bank balances and payable days have increased over the period FY 2017-20.

The preference for cash and liquidity holdback by firms can be traced to cash and TC flow uncertainties triggered by a dysfunctional TC network. This has spillover effects on banking. Hence, a TC intervention is required to mitigate disorderly developments in the financial system, and for pro-growth monetary measures to succeed.

Stringent measures are required to purge covert Chinese imports, a longstanding cause of growth in currency demand and sluggish industrial development.

The writer is former DGM, SIDBI

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