Lower Cash to GDP Ratio is a Reason to Worry, Not Celebrate

Time flies.

In 10 days time, it will be a year, since the prime minister Narendra Modi, made his rather “infamous” decision to demonetise Rs 500 and Rs 1,000 notes.

One of the claimed successes of demonetisation has been that the cash to gross domestic product (GDP) ratio has come down. In a speech made on October 4, 2017, Modi said: “Demontisation के बाद Cash to GDP Ratio अब 9 प्रतिशत पर आ गया है। (after demonetisation, the cash to GDP ratio has come down to 9 per cent.”

Let’s take a look at Figure 1, it plots the currency in circulation (a measure of cash in the financial system) on a weekly basis, from the week before demonetisation was announced.

Figure 1:

Figure 1 clearly tells us that currency in circulation has still not come back to the level it was before demonetisation was announced. As on October 20, 2017, the currency in circulation was at 91.6 per cent of the currency in circulation as on November 4, 2016, four days before demonetisation was announced.

Now let’s calculate the currency in circulation to GDP ratio (cash to GDP ratio). As on March 31, 2017, the cash to GDP ratio had stood at 8.8 per cent. How did things look as on June 30, 2017? The cash to GDP ratio had improved to 9.9 per cent of the GDP.

How did things look before demonetisation? As on March 31, 2017, the cash to GDP ratio had stood at 12.2 per cent. Currently, it must be a little over 10 per cent of GDP (the exact figure can be calculated only once the GDP number as on September 30, 2017, becomes available).

This fall in cash to GDP ratio is being passed off as an achievement and the fact that nation as a whole has become more honest. As Modi said in the speech referred to earlier in the piece: “भाइयों और बहनों, इस सरकार ने देश में संस्थागत ईमानदारी को मजबूत करने का काम किया है। ये सरकार के अथक परिश्रम का ही परिणाम है कि आज देश की अर्थव्यवस्था कम Cash के साथ चल रही है। (Brothers and sisters, this government has worked to strengthen the institutional honesty of the country. It is due to the tireless hard-work of this government that today the country’s economy is running on less cash.)”

There are two points being made here. The first point is that less cash in the financial system means more honesty. The second point is that it is because of the hard work of the government that the country is running on less cash. Let’s take the second point first.

When PM Modi decided to demonetise Rs 500 and Rs 1,000 notes, in one shot he made 86.4 per cent of the currency in circulation useless, overnight. This impacted the economic activity in the country, given that bulk of the economic transactions in India (anywhere from 80 per cent to 98 per cent, depending on which estimate you believe) are carried out in cash.

This slowdown in growth of economic activity has continued. Ultimately, economic activity translates into economic growth.

For the period of three months ending March 2017 and June 2017, the non-government part of the GDP (which forms around 90 per cent of the GDP) has grown by a little over 4 per cent. When growth in economic activity slows down, the growth in currency in circulation is bound to be impacted as well.

So, yes, the hard work of the government has led to a lower cash to GDP ratio, but at the cost of slowing down economic activity. Hence, claiming this as success, is more of trying to build a narrative around demonetisation being successful, rather than being an actual success of any sort.

Another point that needs to be looked at here are digital transactions. Take a look at Figure 2. It plots the total value of digital transactions over a period of time. It does not take RTGS transactions (which are over Rs 2 lakh and are usually carried out by banks to settle among themselves) into account.

Figure 2:

As Figure 2 clearly tells us, the total value of digital transactions is now lower than the months running up to demonetisation. This basically tells us that digital transactions haven’t replaced cash transactions. Hence, economic transactions which were earlier carried out in cash are still being carried out in cash.

This buttresses the point I made earlier about the cash to GDP ratio coming down because economic transactions are not growing at the same rate as they were growing earlier. Hence, a lot of money continues to remain deposited in banks. And this means a slower growth in currency in circulation, and as a result a lower cash to GDP ratio.

Now let’s talk about a lower cash to GDP ratio meaning that the country has become more honest. This is something I have addressed earlier as well, in February. Take a look Figure 3. It basically plots the cash to GDP ratio of different countries.

Figure 3:

Take a look at Figure 3. Japan has the highest cash to GDP ratio at 19.4 per cent. India is nearly half of that at around a little over 10 per cent? Is India a more honest nation than Japan? As per the Transparency International’s Corruption Perception Index for 2016, Japan is the twentieth least corrupt country in the world. India stands at the 79th position, despite having a much lower cash to GDP ratio.

Or take the case of Brazil, which has a cash to GDP ratio of 3.31 per cent. Like India, it is the 79th least corrupt country in the world. Then there is the Eurozone (country’s which basically use euro as their currency). Their cash to GDP ratio is higher than that of India. Is the Eurozone more corrupt than India?

Hence, the link between a low cash to GDP ratio and low corruption is basically very weak. It is basically something that the Modi government has invented in order to build a positive narrative around demonetisation.

To conclude, there is enough data to suggest that a lower cash to GDP ratio is a reason to worry and not a reason to celebrate. Hope, the Modi government, at least internally realises this.

The column originally appeared on Equitymaster on October 30, 2017.