Protesters in Kolkata make their views about India's demonetization known. Photo: AFP / Dibyangshu SARKAR

India is facing a new cash crunch, similar to the one the country faced in the aftermath of demonetization. In November 2016, the Narendra Modi government demonetized 500- and 1,000-rupee notes in order to destroy black or unaccounted wealth, which was supposedly stored in the form of cash.

The Ministry of Finance had said in a press release back then: “Use of high-denomination notes for storage of unaccounted wealth has been evident from cash recoveries made by law-enforcement agencies from time to time.” The irony was that data from the Income Tax Department showed that only around 5% of the black wealth recovered during tax raids was held in the form of paper currency. The decision to demonetize more than 86% of the currency in circulation created a huge cash shortage.

Over the last few days, automated teller machines have been running dry across large parts of the country. The Finance Ministry in a statement released on Tuesday said: “There has been [an] unusual spurt in currency demand in the country in [the] last three months. In the current month, in the first 13 days [alone], the currency supply increased by 450 billion rupees. This unusual spurt in demand is seen more in some parts of the country like Andhra Pradesh, Telangana, Karnataka, Madhya Pradesh and Bihar.”

Basically, the currency in circulation increased by 450 billion rupees (US$6.85 billion) during the first 13 days of this month. Interestingly, between April 6 and April 13, the currency in circulation went up by 330 billion rupees or 1.8%, over a period of just one week.

If we ignore the six months between November 2016 and April 2017, in essence to ignore the extreme effects of demonetization on currency in circulation, for the first two months, it fell dramatically. And in the next four months it rose dramatically – such a huge increase in currency in circulation, over a period of just one week, is a rarity. In fact, there are only five instances of currency under circulation having grown at such speed since 2014.

The election factor

One explanation for this lies in the fact that elections are scheduled in the southern state of Karnataka on May 12. Typically, currency in circulation tends to rise before state assembly elections. This basically means that cash is withdrawn and hoarded in order to be spent during the elections.

The Finance Ministry statement talks about an increase in demand for currency in Karnataka and the neighboring states of Andhra Pradesh and Telangana. Former Reserve Bank of India (RBI) governor Raghuram Rajan talked about this phenomenon on April 6, 2016, when he said: “You can see that there is a spike not just in the state going to polls but also in the neighboring state.”

The week ending April 8, 2016, had seen a week-on-week increase in currency in circulation of 1.84%. This was a period when assembly elections were scheduled in Assam, West Bengal, Kerala and Tamil Nadu. Or take the case of the weeks ending November 6 and November 13, 2015, when the currency in circulation went up by 1.7% and 2.6% respectively. This was the period when assembly elections were scheduled in Bihar.

Take the period of one week ending April 11, 2014, when currency in circulation went up by 1.88% week on week. This was the period when national parliamentary elections were scheduled.

Typically, currency in circulation tends to go up around the time when elections are scheduled in any part of India. Of course, the 2,000-rupee note makes hoarding cash a lot easier than was the case earlier, when the 1,000-note was the highest-denomination banknote. Also, the next-highest-denomination note, after the 2,000-rupee note, is 500 rupees, unlike the 1,000-rupee note earlier. And it takes four 500-rupee notes to replace a 2,000-rupee note. This accentuates the cash crunch.

But that answers only part of the problem. It still does not explain the shortage of cash in areas beyond Karnataka and its neighboring states.

The hoarding factor

One possible explanation lies in the fact that people now have the experience of demonetization and do not want to be left short on cash. Hence they have been queuing up to withdraw cash at ATMs and banks. This is what economists call a self-fulfilling prophecy – the expectation that something will happen is making it happen. Further, this is agricultural sowing season and the need for cash is higher, some experts have said.

One explanation that has been offered is that people’s trust in the banking system has gone down after demonetization and hence they are hoarding on to cash. The problem is that the data do not bear that out.

Figure 1: Currency in circulation. Source RBI and Ministry of Finance

According to official RBI and Ministry of Finance data (see Figure 1), the rate of increase of currency in circulation has been going up and down over the last six months. It hasn’t been a one-way street. If the rate of increase in currency in circulation continues to go up in the months to come, only then can we come to the conclusion that people are systematically hoarding cash over a period of time. This clearly hasn’t happened up until now.

Economy needs more cash

Another theory being offered is that the economy still doesn’t have enough currency or cash going around. The ratio of currency in circulation to gross domestic product before demonetization was over 12%. It fell to 8.8% as of March 2017, in the aftermath of demonetization.

As of March 31 this year, it stood at 10.92%. The belief is that the economy needs more cash, and it isn’t getting that. Data do show that to some extent. Let’s look at nominal GDP growth over two-year periods and the growth in currency in circulation over the same period over the years. This should help us establish some sort of clarity.

Figure 2: The total currency growth in India after demonetization

It is clear that the total growth in currency in circulation  (See Figure 2) has slowed down dramatically over the last two years. It is nowhere near the growth preceding these two years. Nominal GDP growth has also slowed down, but the growth in currency in circulation has slowed much more.

Of course, a part of the growth in currency in circulation has been replaced by digital transactions, but digital transactions are still a very small part of the Indian economy. It is clear that the economy could do with some more currency.

This shortage of currency has now manifested itself into a cash shortage throughout different parts of India. As the RBI said in a press release on April 17, “Printing of the notes has been ramped up in all four note presses.” This should have actually happened long before, especially now that the economy is finally getting out of the ill-effects of demonetization.

To conclude, the fixation of the Narendra Modi government on the idea of paper currency being used as a medium of storage of black wealth is continuing to cost India dearly.

Vivek Kaul

Vivek Kaul writes on the economy and finance. He is the author of the "Easy Money" trilogy and India's Big Government. He tweets as @kaul_vivek

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