The riddle of a dramatic and record surge in currency-in-circulation (CiC) despite large contraction in GDP during FY 2021 and exponential growth in digital payments calls for an explanation.
CiC/GDP and CiC/demand deposits ratios are at record levels. Actually, higher cash-intensity of the economy evolved with a steady increase in mis-invoiced/illicit import from China since mid-2000s. Average CiC growth rate was higher than nominal GDP growth during 2001-20, whereas it was lower during 1980s.
This has occurred despite broadening and deepening of the financial system, financial inclusion at the mass level, surge in digital finance/e-commerce, direct benefit transfers and restrictions on use of cash. The ground realities differ from the currency demand modelling carried out by the RBI.
Fisher Equation
Fisher’s MV=PT version of the transaction demand for money (M) is driven by velocity of money (V), total number of transactions (T) and general price level (P). MV=PT is not a mathematical equation but a conceptual framework to explain the interaction among these variables and direction of their movement. According to American economists Jeffrey Lacker and Stacey Schreft, M consists of currency, demand deposits and trade credit (TC).
Applying this equation to our economy, it is observed that during April-December 2020, PT (taken as proxy for GDP) has drastically declined while currency component of M and demand deposits show Y-o-Y higher growth at 22.1 per cent and 15 per cent compared to 11.8 per cent and 13 per cent during April-December 2019, respectively.
The RBI’s State of the Economy (November 2020 Bulletin) finds cash to total assets of 423 companies increased from 2.7 per cent in H1 FY 2020 to 4.1 per cent in H1 FY 2021. Businesses face acute liquidity gridlock despite a record increase in CiC (currency and demand deposits). So, one can infer from the equation that TC component of M and its velocity declined while businesses’ precautionary cash balances have increased.
Cash-intensity and China
Over time there is unmistakable circumstantial evidence, data points/reports and ground realities which show distinct links between growth in cash intensity and increase in mis-invoiced/illicit Chinese imports. Cash is required to finance the undervalued/illicit part of imports.
China’s WTO membership in 2000, its currency manipulation, export incentivisation combined with reduction in our custom duties and steady appreciation of the rupee (from 2003 to 2008) boosted Chinese imports with a CAGR of 25 per cent in dollar terms during FY 2003-18.This is without counting the value of mis-invoiced imports. This would take place in the form of connivance with Chinese exporters, importers, clearing agents, agents at China/Hong Kong and customs, dumping, pass-through imports, use of e-commerce sites and gift channels. This trend is corroborated by a report by a Special Investigation Team in May 2015 submitted before the Supreme Court, which states that ‘Made In China’ goods are not only flooding the Indian market with cheap goods, but is also generating illicit money in India.
George Herbert (Illicit financial flows between China and developing countries in Asia and Africa, 2020, Institute of Development Studies, UK) finds that lost tariff revenue from under-invoicing of Chinese imports in 2018 could plausibly have been around $690 million for India. There have been other similar estimates.
High denomination currencies
High denomination currencies (HDCs) provide convenience and ease of doing large value business transactions with anonymity. The exponential growth of HDC is linked to financing Chinese illicit imports. The share of HDC (₹500 and above notes) in total currency circulation in value terms have increased from 27 per cent end-FY 2001 to 54 per cent end-FY2005, 76 per cent end-FY 2010 and further to 86 per cent, end-FY 2016. Even after demonetisation, the share remains above 80 per cent. HDC’s growth rate is far higher than nominal GDP growth. During FY 2004-09, HDC’s CAGR was 29.9 per cent, whereas nominal GDP’s CAGR was 14.6 per cent. In FY 2020 growth of HDC was 17 per cent, whereas nominal GDP growth was 7.8 per cent.
During demonetisation almost all HDCs entered the banking network. Except for a moderate amount which was tracked for black money purposes, a large part of the cash flowed back into the economy.
Mis-invoiced Chinese imports pervade our non-food consumption basket, trade and manufacturing structure at a mass level. Demonetisation could do very little in reducing cash intensity. In fact, it has increased now.
Why higher cash-intensity
Demonetisation and GST have resulted in a sudden interruption in the use of informal business funds, especially in the form of trade credit. The fact is that a very high proportion of credit, savings, and investment in the economy are managed by non-bank financial channels especially trade credit. In the pre-GST period, both informal and formal business funds/credit were flexibly used in business transactions. However, GST transactions require formal funds.
There has been a sudden contraction in deployment of informal funds under GST disrupted production, the credit chain and repayment cycle, especially in the unorganised sector. Tighter TC reduces payment flexibility which leads to higher precautionary liquidity hold-up. This cascades into excessive lengthening of the average repayment period.
Dun & Bradstreet data shows that the trade receivables scenario for micro and small companies has deteriorated, following demonetisation and GST. For micro and small companies, around 70 per cent of trade receivables were open for more than 90 days during Q1 2018 as compared to just 45 per cent during 2015.
This problem is amplified in the wake of the corona crisis. Liquidity-bind and payment backlog are greatly aggravated by closure of business activities, disruptions in labour/input supply chain, demand recession, and above all evaporation of willingness to pay and ability to pay. These impacted the trust and confidence channels in TC ecosystem leading to stronger preference for cash sales, lower TC sales and shorter TC tenure.
As such, even in the post-lockdown period, the payment crisis in the TC channel continues. Amplification of uncertainty about cash flows, receipts, fear of intended payment delays, or opportunistic behaviour drive firms to hold more precautionary cash balances. These add to the surge in CiC and decline in money velocity even during post-lockdown period. Sustaining high growth can be difficult when TC volume and velocity decline.
For higher growth, illicit imports from China must be curbed effectively and TC ecosystem needs to be strengthened by reinforcing transactional and environmental trust and generalised credit discipline in the TC network.
The writer is former DGM, SIDBI