Cash is Back: Ill-Effects of Demonetisation are Finally Going Away

We had written about this issue, earlier this month.

At that point of time, the currency in circulation was approaching its pre-demonetisation level.

As of March 9, 2018, the currency in circulation crossed its pre-demonetisation level, for the first time. This is a significant event, which has largely gone unreported in the mainstream media. We wonder why? Dear Reader, guess you know the answer to this one.

Take a look at Figure 1.

Figure 1:The currency in circulation as on November 4, 2016, four days before demonetisation was announced, had stood at Rs 17.98 lakh crore. After that the currency in circulation fell, as people deposited Rs 500 and Rs 1,000 notes in their bank accounts. It fell to low of Rs 8.98 lakh crore as on January 6, 2017, and has had largely had an upward trend since then.

Of course, it is not fair to look at currency in circulation, just in isolation. Then there would be no difference between what passes of as analysis on the social media and us.

The currency in circulation is also a function of the size of the economy. Between November 2016, when demonetisation happened and now, the economy has also increased in size. Hence, we need to adjust for this, and the right metric to look at is the currency in circulation to the Gross Domestic Product (GDP) ratio.

In order to come up with this ratio for the end of this financial year, we will have to project the currency in circulation. A projection for the GDP is available.

We basically look at the weekly growth rate of currency in circulation over the last one year (i.e. from March 10, 2017 to March 9, 2018). We ignore the rate of increase in currency in circulation from January 6, 2017 and March 2, 2017, because it was growing at a very fast rate at that point of time.

Using the weekly rate of increase of currency in circulation from January 6, 2017, onwards, is likely to lead to a higher currency in circulation at the end of this financial year and we like to be slightly conservative in our calculations.

Using the rate of weekly increase in currency in circulation between March 10, 2017 and March 9, 2018, the currency in circulation at the end of March 2018, is likely to be around 18.53 lakh crore. As of March 9, 2018, it was at 18.14 lakh crore.

The GDP at the end of the year is projected to be at Rs 167.51 lakh crore. This means a currency to GDP ratio of 11.1%. Take a look at Figure 2, which basically plots, the currency to GDP ratio of the Indian economy, over the years.

Figure 2:The currency in circulation as of March 31, 2017, had stood at 8.8% of the GDP. By March 31, 2018, it is expected to be at 11.1% of GDP, a jump of 230 basis points. One basis point is one hundredth of a percentage. While, this has still not crossed the pre-demonetisation level, it is a tremendous recovery from the March 2017 low.

There are multiple interpretations that can be made from this. Firstly, it tells us very clearly that Indians have gone back to cash as a medium of exchange. It also tells us very clearly that fundamental habits cannot be changed overnight, a point we have been hammering away at for a while now. An economy which used cash for close to 98% of its transactions (in volume terms), cannot be suddenly expected to use substantially less cash.

The increasing currency in circulation as a proportion of the GDP, is a sign of people carrying out more economic transactions with each other than they were in the past. Only when economic transactions happen do people need cash or currency to pay for stuff. If economic transactions are not happening, the currency can continue to stay in the bank account. Only, when transactions start to happen, money is withdrawn from banks and currency in circulation goes up.

Of course, many transactions are carried out in cash. Informal economy forms a huge part of India’s total economy. It also employs a major part of the workforce.

Depending on which estimate you want to believe the informal economy forms around 40-45% of India’s economy and employs anywhere between two-thirds to 92% of its workforce. The currency in circulation going up is clearly good news for the informal sector.

It shows that life seems to be gradually getting back to normal, for this sector, which was badly hit in the aftermath of demonetisation. This should gradually translate into good news for the formal sector as well. If the informal sector does well and people working in it earn money and spend it, the firms operating in the formal sector are bound to benefit, as well.

Of course, the propaganda these days is that everybody who operates in the informal sector is bad, because they don’t pay tax. But that is incorrect. As we have written in the past, a bulk of the individuals working in the sector do not come under the tax bracket and hence, they don’t pay tax. Hence, painting everyone with the same brush is neither fair nor required.

Having said that, there are people and firms operating in the informal sector not paying their fair share of taxes. This means the income tax department needs more efficient targeting, instead of painting everyone with the same brush, as the government has been doing since November 2016. But that is easier said than done.

Propaganda is way easier than doing the right things.

The column originally appeared on Equitymaster on March 22,2018.