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Demonetisation and Cash ShortageASHOK K LAHIRI

Vol. 51, Issue No. 51, 17 Dec, 2016

Ashok K Lahiri (ashoklahiriin@yahoo.com) is Chairman, Bandhan Bank, and former ChiefEconomic Adviser, Government of India.

Demonetisation of ₹500 and ₹1,000 notes has resulted in a cash shortage. Non-cash mediumof payments may be encouraged by this shortage, but, with supplies only from the domesticcurrency presses, the shortage is unlikely to disappear by the end of 2016. Import ofcurrency printed abroad may provide a solution for ending it sooner. The impact of theshortage, if it continues, will be fully felt in the last quarter of 2016–17. Its growth impact in2016–17 could be 0.7%–1.3% depending on how much shortage continues, and for how long.

The decision of the government and the Reserve Bank of India (RBI) to withdraw the legaltender status of the preexisting ₹500 and ₹1,000 currency notes beyond 8 November 2016and the resulting cash shortage have been matters of intense debate. The measure,according to the government, was motivated by the twin objectives of curbing the menace offake Indian currency notes and for eliminating black money.

Interestingly, even during the two previous episodes of demonetisation of high value notesover `100 in India, on 12 January 1946, and on 16 January 1978, the objective of theexercise was containing black marketing or black money.

The aim of this article is to analyse two questions. First, when is the cash shortage likely todisappear? Second, what is likely to be the impact of the cash shortage on growth in theeconomy?

How Long Will the Cash Shortage Persist?

Initial popular sentiments appeared to endorse the government’s announced crusadeagainst corruption and black money with demonetisation. Problems have arisen with theresulting cash shortage, disrupting people’s lives and economic activity. A temporary cashshortage may have been ignored, but the persistence of the problem has raised questionsabout how long this shortage is likely to persist.

The government has claimed that the shortage will disappear by the end of the currentcalendar year. Some commentators (Chaudhuri 2016) have said that it will take muchlonger, perhaps as long as up to May 2017. So, how long will it take? The answer depends

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on how much of the demonetised currency notes will have to be substituted with valid notesof equivalent value, and how soon they can be printed and distributed.

How much of the demonetised notes will have to be substituted with valid notes in turndepends on two factors. First, how much was presented for over-the-counter conversion,and how much will be deposited in bank and post office accounts. In 1946, when currencynotes of the value of ₹500, ₹1,000 and ₹10,000 were demonetised by an ordinance, suchnotes in circulation were of ₹143.97 crore. By the end of 1947, ₹134.9 crore, or 93.7% wereexchanged. In 1978, when currency notes of denominations ₹1,000, ₹5,000 and ₹10,000were demonetised, the total amount in circulation was ₹145.42 crore. Of this, 89% or₹129.4 crore came back for exchange.

It is reasonable to assume that, for the fear of detection, some “black money” circulating inthe form of currency will have a tendency not to come back for exchange. Given thedecrease in the proportion surrendered for conversion between 1946 and 1978, and theincreased efficiency of tax administration and banking industry in 2016 in monitoring suchconversion, 85% can be taken as a conservative estimate of such conversion in the currentround. An optimistic estimate can be 80%.

Second, even when the demonetised notes are deposited in bank or post office accounts,these may be kept as deposits, without necessarily being withdrawn in the form of currency.It is likely that the current cash shortage may have given a stimulus to the banking habitsand cashless transactions among the population. Compelled by the cash shortage, many mayhave realised the potential of the debit and credit cards, online transfers, and other digitalpayment facilities such as mobile payments. Furthermore, the preference for cash intransactions is partly motivated by the objective of avoiding detection for tax purposes. Ifavoiding detection becomes more difficult, tax compliance may improve and also exert adownward pressure on the transaction demand for cash relative to that for deposit.

It is important to note, however, that the demand for currency relative to deposit moneyalso depends on the confidence that people have in the banking system and its ability toconvert deposits into cash at sight. During the Great Depression in the United States, thatbegan in November 1930 and persisted for two and a half years, nominal gross nationalproduct fell by 38%, deposits fell by 33%, and currency with the public rose by 55%,resulting in a rise in the currency–deposit (CD) ratio (Boughton and Wicker 1979: 405). Willthe recent demonetisation exercise, by shaking up public confidence in the banks’unrestricted ability to convert deposits into cash, also work the same way in enhancing theCD ratio? Given that people seem to have accepted the demonetisation as a one-off exercisefor tackling black money, this stimulation of the demand for currency relative to deposits islikely to be negligible.

As Figure 1 demonstrates, the CD ratio in India has been on a declining trend. But thisratio is still almost 50% higher than that in Organisation for Economic Co-operation and

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Development (OECD) countries, and is likely to go down further. The recent demonetisationmay give a fillip to the process, at least temporarily. What happened in Europe during theEuro cash changeover in 2002 is likely to happen in India as well following the recentdemonetisation, namely, a sharp reduction in the CD ratio followed by slow recovery (ECB2003). A reduction in interest rates because of excess cash in banks is likely to reduce theopportunity cost of holding currency relative to deposits in banks, and help the equilibrationof the CD ratio.

Of the ₹16.6 trillion currency in circulation on 31 March 2016, a total of 85.2% (₹14.2trillion) was in ₹500 and ₹1,000 notes. Of this ₹14.2 trillion, 3.98% (`0.7 trillion) were heldby banks. Assuming the same proportion of ₹500 and ₹1,000 notes held by banks on 8November, the value of ₹500 and ₹1,000 notes held by the public are obtained as ₹7.5trillion and `6.1 trillion, respectively.

Note that on the eve of demonetisation on 8 November, the money stock must have beenhigher than the stock on 31 March 2016. Between 31 March 2015 and 31 March 2016, ₹500and ₹1,000 notes in circulation grew by 19.7% and 12.7%, respectively. So it is reasonableto assume that ₹500 and ₹1,000 notes held by the public on 8 November could have beenaround ₹8.3 trillion and ₹6.5 trillion, respectively, that is about 10% and 6.5% higher thanthe corresponding figures on 31 March 2016. Based on these assumptions, number of ₹500and ₹1,000 notes with the public on 8 November 2016 is obtained as 16.6 billion and 6.5billion, respectively (Table 1). Though all the old ₹500 and ₹1,000 notes held by banks willalso have to be substituted by other notes, it need not be done immediately as long as theexchange of such notes held by the public goes on smoothly and total deposits do not dipbelow the level on 8 November.

If a uniform 15% of such notes do not come back because of the measures against black

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money, then only 14.1 billion ₹500 notes and 5.5 billion ₹1,000 notes will be deposited intoaccounts or presented for conversion into other notes. A more aggressive assumption of20% of such notes not coming back yields 13.3 billion ₹500 notes and 5.2 billion of ₹1,000notes for conversion or deposits (Table 1).

How much of these deposits of old demonetised notes will be withdrawn in the form ofcurrency is the next important question. Between 28 October and 11 November 2016,currency with the public went down from ₹17.0 trillion to ₹15.3 trillion, while currency withbanks rose from ₹759 billion to ₹2.6 trillion, time deposits from ₹96.5 trillion to ₹97.5trillion, and credit to the commercial sector declined from ₹79.6 trillion to ₹79.0 trillion. TheCD ratio, as a result, went down from 15.9% on October 28 to 14.1% on 11 November 11,but not because people wanted less currency, but because they could not withdraw casheven if they wanted to.

While some of the “de-hoarding” of high denomination notes is likely to be reversed overtime, the CD ratio is unlikely to go back to its 28 October value. If the CD ratio does not goback up beyond 15%, which is likely for the reasons already adduced and the reduction incurrency with the public is entirely in terms of ₹500 and higher denomination notes, theholding of such notes may go down by a further total of ₹1 trillion which is the rise in thetime deposits with banks between 28 October and 11 November. This is over and above theamount that does not come back as deposit at banks or for conversion into valid notes underthe two scenarios.

Distributing this ₹1 trillion reduction in the same ratio as ₹500 and ₹1,000 notes circulatingon 28 October, that is, 56.2% and 43.1%, the number of ₹500 notes that will be demandedin the form of cash is obtained as 12.98 billion under the conservative scenario and 12.15billion under the aggressive scenario. Since what is being supplied in terms of currencynotes in denomination higher than ₹500 is ₹2,000, under the simplifying and somewhatheroic assumption that the public will willingly accept the substitution of ₹1,000 old notesby the new ₹2000 notes, the corresponding numbers for ₹2,000 notes are 2.53 billion and2.37 billion.

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The payments system in India indeed is in “the cusp of a revolution” (Joseph et al 2013). TheIndian payments revolution of the future may be as fast as the revolution in mobiletelephony in the recent past. But India still is a cash-intensive country. Though it may bemoving towards being less cash-intensive, the on-going payments revolution by itself isunlikely to solve the post-demonetisation cash shortage in the immediate future.

Bank notes are printed at four note presses: at Currency Note Press, Nashik and Bank NotePress, Dewas, both owned by Security Printing and Minting Corporation of India Ltd.(SPMCIL), and at Mysuru and Salboni, owned by Bharatiya Reserve Bank Note MudranPrivate Limited (BRBNML), a wholly-owned subsidiary of the RBI. SPMCIL is wholly ownedby the Government of India. The printing capacities of these four units are not readilyavailable in the public domain. But, the RBI’s Annual Report 2016 provides the indents forand supply of currency notes by the four units during the three years (Table 2).

Table 2 does not paint a rosy prospect for the rapid amelioration of the cash shortage. Thetotal number of pieces of currency supplied was 20.9 billion in 2013–14, 23.6 billion in2014–15 and 21.2 billion in 2015–16. Supply fell short of indent by 17.5%, 2.3% and 11.3%in these three years in sequence. The maximum ₹500 and ₹1,000 notes supplied in the lastthree years were in 2014–15, and at 5.0 billion and 1.0 billion, respectively.

The required number of ₹500 notes in the two scenarios to wipe out the cash shortageis 12–13 billion pieces, which is more than twice the maximum produced in 2014–15.Similarly, even if the old `1,000 notes are replaced by ₹2,000 notes, the correspondingrequirement of ₹2,000 notes at 2.4–2.5 billion pieces exceeds the maximum annualproduction of ₹1,000 notes achieved in 2014–15 by a factor of more than two.

The maximum number of pieces of currency notes, irrespective of denominations, producedby all the four currency presses together was 23.7 billion. The total requirement of `500 and₹2,000 notes for removing the cash shortage is between 14.5 and 15, 5 billion, or between32 and 34 weeks of the rate of production achieved in 2014–15. Thus, even if the currencypresses were to produce only ₹500 and ₹2000 notes with the same level of efficiency as in

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2014–15, the shortage would disappear only by mid-June or the first week of July 2017.

A little more than a fortnight before the demonetisation, it was reported that “[The RBI] hasvery nearly completed preparations for introducing this new high-value currency. …Thenotes have already been printed, and their despatch from the currency printing press inMysuru has commenced” Sridhar and Vageesh (2016). While no figures are available abouthow many ₹2,000 notes were printed before November 8, it is assumed that such productionwas negligible at around a couple of million at most.

Meeting the demand for ₹500 and ₹2,000 denomination notes in 50 days would require adaily production of 290 to 310 million pieces, which is 106 to 109 billion pieces per year.Meeting the 50-day deadline thus, requires the currency printing presses to ramp up theirproduction at least four-fold. Operating three shifts instead of two will increase productionby no more than 50%. A four-fold enhancement of output of the four currency printingpresses within a short time may be a mission impossible.

A quick way to relieve the shortage would be to consider the strategy that the governmentunder Prime Minister Atal Bihari Vajpayee adopted in 1998. Among other things, it decidedto import 3,600 million pieces of printed notes adding up to a face value of ₹1 trillion torapidly wipe out the cash shortage (Vikraman 2016).

How the Cash Shortage will affect Inflation and Growth

Currency and deposit money or credit cards are not perfect substitutes as medium ofexchange in many transactions. For example, daily wage of an unskilled or semi-skilledworker, retail purchases from a street vendor, or even vegetables in the mandis orwholesale markets in many places cannot be paid for in anything but cash. The cashshortage has affected trading and production in many segments of the informal economy. Anadditional cost is the man-days lost queuing up at banks for conversion or deposit of oldcurrency.

The cash shortage may have already affected the prices of perishable goods and services.Prices of vegetables in wholesale markets, according to newspaper reports, have fallensignificantly. Vegetable prices go down around this time of the year because of seasonality,but cash shortage reportedly was an additional factor. Overall inflation may come downbecause people have less of one common medium of exchange, namely cash, to transact, butthis decline in inflation will be tempered by how much output also falls because of the lackof cash as working capital.

Money is the lubricant that keeps the wheel of economic activity moving. A standard, albeitsimplistic, approach to analysing the impact of the cash shortage is to fall back onCambridge equation of the quantity theory of money. Three scenarios are considered:(Table 3).

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In scenario I, both currency with the public and the demand deposits at the end of March2017 are 10% higher than the corresponding figures a year ago. Effectively, in scenario I, atthe end of 2016–17, currency with the public gets more than restored to what it was beforedemonetisation. Although the year-on-year (y-o-y) growth of both currency with the publicand demand deposits is the same 10%, post-demonetisation, growth of currency is over ₹2.3trillion compared to only ₹84 billion growth in demand deposits.

Under scenario II, y-o-y growth of currency and demand deposits is 6.5% and 5%,respectively. While the y-o-y growth in demand deposits is 5%, such deposits decline by₹419 billion post-demonetisation signifying a shift from demand deposits to currency. At theend of 2016–17, while currency with the public exceeds the pre-demonetisation level by₹556 billion in scenario I, the pre-demonetisation level is just about restored under scenarioII.

Scenario III considers the case where the authorities fail to make up for the cash shortageby the end of March 2017, and currency with the public, with y-o-y growth of only 4%, fallsshort of the pre-demonetisation level by ₹402 billion. Demand deposits grow, y-o-y, only by4%, and like under scenario II, is ₹670 billion lower than what it was on 11 November 2016post-demonetisation.

In all the three scenarios, the growth of M1 from 11 November 2016—the first reportingFriday for banks after demonetisation—to 31 March 2017 has been assumed to follow astraight-line path of equal absolute change every fortnight. Gross domestic product (GDP) atcurrent prices for the third and fourth quarters of 2016–17 is projected by assuming theincome velocity values.

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Needless to say, Table 3 is for illustrative purposes. It shows that the impact of the cashcrunch, if it persists, is going to be the most severe in the fourth quarter. Almost half thethird quarter had passed before the cash crunch set in. If the cash shortage persists,nominal growth could be as low as 4%–7% in the fourth quarter, depending on how severethe shortage is.

GDP for 2016–17 is obtained by adding up the quarterly GDP figures. Growth declines from11.6% in scenario I to 10.2% in scenario II and 9% in scenario III. Under the heroicassumption that nominal growth will be coming equally from real growth and inflation, thegrowth impact of the cash shortage is 0.7%–1.3% depending on how much of the cashshortage continues to persist and for how long. Of course, over the long run, how theeconomy will be affected will depend on how far the demonetisation is followed up bysuitable and effective measures to control the shadow economy.

Conclusions

Demonetisation of ₹500 and ₹1,000 notes on 8 November 2016 has become a matter ofintense debate. Production of high value notes have been discontinued by many countriesbecause these are often used for money laundering and organised crime. The Indiandemonetisation is considerably different from such scrapping of high value notes. Suchscrapping typically involves stopping the production of high value notes and asking thebanks to return such notes for destruction by the central bank. But the high value notescontinue to be legal tender. In India, the old ₹500 and ₹1,000 notes have ceased to be legaltenders, and not only does the production of new `500 notes continue, but a new ₹2,000note has been introduced as well.

The post-demonetisation situation has been complicated by a cash shortage disruptingpeople’s lives and economic activity. Sentiments of a large section of the people appear toendorse the government’s announced crusade against corruption and black money withdemonetisation. But the persistence of cash shortage may not only erode such support butalso affect the economy, particularly in the fourth quarter of 2016–17. It is imperative thatthe cash shortage be rapidly removed by suitable action, if necessary through import ofcurrency printed abroad.

High value notes have been demonetised three times so far in India—in 1946, 1978 and2016. On all the three occasions, the objective was to contain black money. The outcomeafter the two previous exercises in 1946 and 1978 has not been very inspiring. This time,there appears to be a concerted plan of action, including changes in tax laws and legaltreatment of benami transactions. Only time will tell whether 2016 is different from 1946and 1978. In 1946 and 1978, 6.3% and 11%, respectively of the demonetised currency didnot return to the banking system. If 15% or more, that is, at least ₹2.3 trillion worth of old₹500 and ₹1,000 notes, does not come back for exchange, it will give an early indicationthat this time may be different from the past. But even after clearing the muck of currency

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that was mediating illegal or unaccounted transactions in the recent past, what will remainis the larger job of preventing its accumulation in the future.

References

Boughton, James M and Elmus R Wicker (1979): “The Behavior of the Currency–DepositRatio during the Great Depression,” Journal of Money, Credit and Banking, Vol 11, No 4, pp405–418.

Chaudhuri, Saumitra (2016): “Even as world changes under Trump, India’s CurrencyShortages Will Stay for Months,” Economic Times Blogs, November 15,http://blogs.economictimes.indiatimes.com/et-commentary/even-as-world-ch....

ECB (2003): “The Demand for Currency in the Euro Area and the Impact of the Euro CashChangeover,” Monthly Bulletin, European Central Bank, January, pp 39–51.

Sridhar, G Naga and N S Vageesh (2016): “Coming soon to your wallet: ₹2,000 notes,”Hindu Business Line, October 21.

Joseph, Nikhil, Ruben Korenke, Benjamin D Mazzotta and Bhaskar Chakravorti (2013):“Cash Outlook—India,” Working Paper 13–01, Institute for Business in the Global Context,Fletcher School, Tufts University.

Lahiri, Amartya (2016): “The Demonetisation Boondoggle,” Business Standard, 4 December.

Varma, Subodh (2016): “Veggie Wholesale Rates Crash, Retail Prices Only Dip In Cities,”Economic Times, 2 December,http://economictimes.indiatimes.com/news/economy/agriculture/veggie-whol....

Vikraman, Shaji (2016): “In fact: How NDA under Atal Bihari Vajpayee Saw HighValue Notes,” Indian Express, November 16.