Demonetisation: The curious case of cash shortage and currency hoarding

It’s been well over a month since the legal tender status of the old Rs 500 and 1000 notes (referred to as specified bank notes or SBNs) was withdrawn. Everyone in the country, including foreigners in India, in different ways and in different degrees, has been experiencing the consequences of the cash shortage. Clearly from their experiences everyone can see that the shortage is also far from being over. This, however, begs a question that may not be obvious at first sight. If it was true that recipients and generators of black income have, over the years, been stocking up large cash holdings, would the economy have not been experiencing periods of cash shortage?


After all, how does it matter if the cash is stacked up in the houses and safes of some who are not going to release it for a long time or is with the banks and the RBI? Either way it would not be available for immediate use by others.


In other words, the hoarding of cash by some people would be equivalent to withdrawing that cash from effective circulation as neither the hoarders nor anyone else would be using it to make payments. The total currency issued by the would therefore get divided into two parts – one that was part of a black cash hoard and another part in active circulation. If the hoarded part tends to be large relative to the total currency issued and the active part small, then the only possible explanation for us not feeling the before would have to be that a much smaller amount of cash in active circulation (than the total amount issued by the RBI) was enough to meet most of our requirements. Thus, it stands to reason that the replenishment of a smaller amount of currency, than what was rendered useless by demonetisation, should be able to restore normalcy, provided of course that this replenishment does not go into converting the cash hoards of India’s black money holders.


To put it slightly differently, the greater and longer the pain of demonetisation, the greater is the degree to which one its key premises – namely, that large amounts of black incomes are held in the form of cash holdings – is undermined.


On December 10, over a month into the Modi government’s exercise, figures from the imply that about Rs 7 lakh crore was available to the public. This consists of the valid currency withdrawn from banks against deposits or conversion of SBNs between November 10 and December 10 (Rs 4.61 lakh crore) and the old currency of smaller denominations held by the public on  November 8 (roughly Rs 2.4 lakh crore). By December 10, a total of at least Rs 12.44 lakh crore of the invalid SBNs (more than 80% of the total in circulation on November 8) have also been deposited into bank accounts.


The balance of these deposits, after deducting the amount withdrawn, or about Rs 8 lakh crore, was also usable by the depositors to make payments through non-cash modes (on which there is no restriction). Despite some payments having shifted to such modes, bank deposits and the currency of Rs 7 lakh crore are certainly not proving to be enough to meet the payment requirements of the public. Therefore, even if one assumes that some part of the Rs 12.44 lakh crore deposited is black money, that a large portion of it was inactive cash stashed away by their holders seems unlikely. The shortage of currency therefore is still acute and is likely to be felt for an extended period as the supply of new currency by the is still below a third of the amount invalidated from November 9.


There are three basic ways in which people usually get cash in their hands. They could receive it from someone else as payment for something – a service provided or a good sold. Alternatively, they withdraw it from their bank deposits at a bank branch or making use of an ATM. A third way is borrowing cash from someone who already has it or receiving it as some kind of transfer (a gift, parents giving pocket money to their children, a bribe, etcetera). The shortage of cash is being experienced in all these different ways – apart from the inability to withdraw from bank deposits is the absence of buyers who would make payments with currency or lenders who can lend in that form. Each of these ways by which people get cash involves its transfer between themselves or banks – the circulation of currency rather than its standing still. These cannot change the quantity of the total currency in circulation, which is defined as the sum of the currency with the public and the cash reserves held by banks (in normal times the former is close to 96% of the total).


The total currency in circulation only increases through a combination of mechanisms which involve the using currency printed by it (and increasing its notional liabilities) in transactions with others. The government increasing its spending by borrowing from the RBI, increase in the borrowing by banks from and acquisition of foreign exchange assets by the are the main mechanisms for increases in currency in circulation, most of which ends up in the hands of the public through the credit activities of banks and the withdrawals by the public from their deposits. Currency in circulation can also decline in any period through these same mechanisms in the net acting in the opposite direction. This is precisely what has happened on a significant scale due towith banks transferring the SBNs received from the public to the RBI. Between November 4 and December 9, 2016, the currency in circulation fell from Rs 17.97 lakh crore to Rs 9.81 lakh crore (with the latter including in addition the SBNs still in the hands of the public or with banks).


Instances of significant decline in the currency in circulation are exceptional and the normal trend is of gradual additions to the stock of the currency in circulation – in tandem with the expansion of economic activities and inflation, both of which increase the aggregate annual value of transactions.


Thus, of the stock of currency in circulation on November 4, 2016, less than 15% consisted of the part added over the previous year (and there would be some additional part which would be the replacement of older worn out currency). This also indicates why replacing the invalidated currency quickly is proving to be so difficult – for such replacement the available printing capacity must produce currency which in value terms would be more than five times what it would normally need to print in a full year. Replacing the Rs 1000 note with a note one does not proportionately reduce the burden of printing as the very existence of a note also implies indirectly that a larger number of notes of smaller denomination will be required. As this process of replacement drags on, the shortage of currency will continue to result in a contraction in the total value of transactions and the economic activities contingent on them, with effects that may go beyond that time.


While the currency in circulation or with the public increases incrementally every year, income is earned year after year. This is as much true for black income earners as for anyone else and the total black income would be made up of some part of the recorded or official national income and some part which remains undetected or hidden.  If black income earners were to accumulate cash every year, the only in which this could happen is if the excess of the black income received by them during each year in cash exceeded the expenditure of cash over the same period.


Black money proportion


Let us now consider three possible proportions of black income to the officially estimated national income of India – 5%, 10% and 25%. Let us assume that the proportion of black income that remains unspent every year and is accumulated as cash is 100% in the first case, 50% in the second and just 10% in the third. In either case, the currency holding out of the black income generated over just the five years from 2011-12 to 2015-16 would have been nearly Rs 25 lakh crore – about Rs 10 lakh crore more than the value of SBNs in circulation on November 8 and close to Rs 8 lakh crores more than the total currency with the public. That of course is impossible. Even if we were to in each case halve the proportion hoarded as cash, the total cash holding before of black income earners should have been more than the value of SBNs deposited with banks up to December 10.


It follows from the above numbers that we are only allowed to make a choice between two mutually exclusive positions – either that the proportion of black incomes in India’s national income is relatively large (say close to 25%) or that the proportion of that income which is hoarded as cash is large (say between 50 and 100%). We simply cannot hold both positions and yet that is precisely what the spokespersons of the ruling dispensation have been doing since the day was announced and trying to convince everyone else to accept. They are asking us to accept as true what official statistics themselves unambiguously say is impossible. Their argument in any case is implausible. Income received in the form of cash always tends to be spent because even preserving that value under inflationary conditions or increasing it involves spending. Even someone whose sole interest is accumulating money would also therefore want to spend cash rather than simply hold onto it. This means that while the black economy may be the source of several problems – the inactivity of cash with its attendant economic consequences is not one of them. Instead, money hoarding, both forced because you cannot spend it and then further induced by the uncertainties in getting cash, is the result of demonetisation.


The initial campaign in favour of sought to create an impression that wealth of black income earners held in cash would be destroyed because the fear of it being revealed would deter them from depositing their cash holdings in banks. With this presumption falling flat on its face given the magnitude of the deposits already made with more than two weeks of such depositing activity remaining, the tune has changed. Now it is being contended that has ensured widening of the tax base and the uncovering of black incomes as it has forced black money into the banks, and therefore on record and subject to taxation.


This argument, however, also repeats the error of confusing the cash holding with income – if cash held at any point of time is only a small part of black income, levying a tax on the value of the cash deposited, even if it will happen, would generate only a small part of the tax due on that income.


Additionally, in all business and commercial activities, cash is also held to make expenditures which are costs and therefore not part of income. It is absurd therefore to assume that, even after the income-tax officials can go through the mountains of data generated by this exercise, a large part of taxable income that escapes detection will get revealed through the exercise of forcing cash to be deposited in accounts.


One can also look at this another way. How much does the forced deposit of their cash with banks increase the value of bank deposits held by the public? Rather insignificantly it turns out because relative to the currency holding, the value of bank deposits was very high even before demonetisation. On October 28 2016, as compared to the public’s currency holding of Rs 17.01 lakh crore, the aggregate value of their bank deposits (current, savings and term) was Rs 106.97 lakh crore. This reflected a long-term trend of change since independence, when currency with the public used to be over one and a half times the value of their bank deposits. Because of demonetisation, the currency with the public including the SBNs still in their hands declined by 46% by November 25, 2016. At the same time the increase in the value of their bank deposits was barely 5%.


What is the huge increase in detection that will take place with this small an increment in deposits?  


In any case, currency is not simply withdrawn from banks – it is also deposited. At all times, some deposit currency with banks while others withdraw and any change in the currency with the public is only the difference between what has been withdrawn and what is deposited. Thus, in 2015-16, the withdrawals of cash from ATMs alone over the year added up to more than Rs 25 lakh crore, while the increase in the currency with the public that year was barely Rs 2.11 lakh crore – and both these figures are from the RBI. Obviously, a very large amount of cash, much greater than the stock of the currency with the public at any time was also deposited with banks during the same year. This also means that the one-time depositing of currency compelled by does not achieve very much in terms of additional information generated for India’s tax authorities.