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Four years ago, on the 8th of November 2016, at around 8:15 p.m the Prime Minister announced that all 500 and 1000 rupee notes would no longer be legal tender from midnight onwards. The announcement basically rendered 86% of the currency in circulation (CiC) – & an astounding 99.3% of the total value of the currency in the economy – valueless

The move was aimed at tackling the shadow economy and the counterfeit currency and black money that was being used to fund terrorist and other illegal activities in the country. With regards to these stated aims, the consensus amongst analysts is that the decision failed. The reason has to do with the fact that those who hoard illegal wealth, do so in the form of gold or benami properties, while only keeping approximately 6% in cash. Nearly all of the money that was demonetized was injected back into the economy by 2018.

The demonetization led to a host of other issues in the economy 

Immediately following the aftermath, hundreds and thousands of people lined up outside banks in order to deposit their now illegal notes in exchange for legal ones. Withdrawing money from ATMs became very difficult and people were restricted to a certain amount per day, as was the case with the exchange as well. Across the country, people suffered and economic activity was significantly affected. In fact, the effects of demonetization were being felt even in 2019 with many observers stating that the slowdown in the economy was caused by the government’s policy.

One of the intended outcomes of the policy was to force an increase in the use of digital payments, which naturally happened due to a lack of options. Debit and credit card use went up and digital cash transactions facilitated by UPI also increased. While card usage returned to normal levels a year later, digital transactions continued to increase and the government successfully compelled the adoption of this method of payment.

Why is CiC increasing?

One would assume that with increased usage of digital payments, the CiC would gradually decrease, however, this has not been the case. Between 1971 and 2020, the RBI has identified four distinct periods when the growth of CiC was especially high (+17%), these are 1987-90, 1993-96, 2005-09, and 2017-20.

Of these 4 periods, 2017-20 was the highest with an average growth of 22.7% per year. This was largely driven by the figures in 2017-18 when the growth of CiC was 37.7%.

According to the RBI, there are 4 main factors that determine demand for currency in a country.

  1. The volume of transactions in the formal and informal sectors.

  2. The extent of precautionary cash holdings in relation to speculative demand.  

  3. The rate of change and deepening of financial innovation which impact transaction habits, and

  4. Demand for home currency beyond its national jurisdiction (eg. Nepal and Bhutan have a need for INR).

‘1.’, in other terms, would refer to the level of economic activity in a country which can be measured by GDP growth. Between 2017 and 2020, GDP growth in India has been very poor, so this doesnt explain why CiC has been so high. At the same time, ‘3.’ speaks to the advent of digital payments systems which, like we have already mentioned, has seen usage of grow tremendously since demonetization. ‘4.’ is unlikely to be an important factor for this time period as there hasn’t been abnormal foreign demand for Indian currency. 

The RBI has stated that the high levels of currency growth seen is a direct consequence of efforts undertaken by the government to re-monetize the economy. Hence, it has grown despite the low levels of GDP growth and the growing prominence of digital payments.

The government introduced new 500 rupee and 2000 rupee notes, and later on started issuing 200 rupee notes as well. It also redesigned the existing 50 and 100 rupees notes.

2017 saw the highest injection of currency into the economy and this trend gradually decreased as the years went on. The figures still speak to the extent of the re-monetization efforts undertaken by the government. Additionally, when we look at 2020 in particular, ‘2.’ from the above list becomes relevant.  The COVID-19 pandemic has pushed people to hoard cash in favour of leaving it with the banks, due to fear or uncertainty, which is also increasing demand. This is being observed all over the world.

What are the consequences?

The problem with having too much money in circulation has to do with the fact that it causes inflation. When supply remains stable, having high CiC leads to demand side inflation as people have too much cash chasing the same number of goods. In the context of 2020, this effect gets even worse as there is a global recession going on caused primarily by supply side shocks.

At the same time, the CiC to GDP ratio has remained relatively stable. Prior to demonetization, the ratio was at 12% which is the target for the Indian economy. Immediately after, the figure dropped drastically to about 8.6% but has since recovered and is currently at around 11.3%, which is good news.

What this tells us is that the current levels of CiC in the economy are not cause for concern. The unique circumstances brought about demonetization have necessitated the need for increased injection of money into the economy. Added to that is the fact that the pandemic calls for fiscal stimulus as a measure against the recession. As long as the CiC to GDP ratio is on course to meet the RBIs target, there will be no adverse effects felt by the economy.

For feedback, thoughts and views, please write to pavan@bclindia.in 

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