The announcement by the Reserve Bank of India on Friday withdrawing Rs 2,000 denomination notes from circulation has predictably brought back the memories of demonetisation and the uncertainty of holding cash. Some would argue that this is not a big deal: the circulation of Rs 2,000 currency note was in any case shrinking and it was inevitable that it would be withdrawn some time or the other.
The Reserve Bank announcement was carefully worded to reinforce this view. The notes will remain legal tender and time has been given to exchange or deposit the withdrawn notes until September 30. Clearly some lessons have been learnt from the disastrous demonetisation of 2016. There was no dramatic address to the nation. It is presented as a normal exercise to implement the “clean money” policy, removing damaged or soiled notes from circulation, and to get rid of the notes that are, in any case, not used much in daily transactions.
There is no reason to mourn the demise of these purple pink notes. Whatever the reason for their original circulation, the purpose has been served. The more relevant question is on the wisdom of the abrupt announcement of their withdrawal by the Reserve Bank. A process of gradual withdrawal was already in place so that the notes in circulation shrunk from around 37% at their peak to around 10% currently. Indeed, the Reserve Bank had stopped printing these notes in 2018-’19. So in due course, the entire series would have gone out of circulation.
Instead the sudden announcement creates some doubt that there could be other reasons besides wanting to have clean notes.
Indeed, some narratives have begun to emerge, which leads to the suspicion that the move is not entirely what it seems to be. There is talk once more of a strike against black money, that demand deposits will get a boost, reviving chatter about less cash and more digital economy. If the experience of demonetisation is any guide, we can forget about this being achieved. The currency-to-demand deposits ratio has not changed much since 1995, standing at around 1.4, barring a brief spurt of deposits post-demonetisation. Anyone observing the trends in the circulation of currency since the 2016 demonetisation will know that the demand for cash remains very strong and its use is widespread in the economy. .
Why is the demand for cash so high despite the shock of demonetisation and the substantial growth in digital payments? This has been observed not just in India but in several major economies. Studies conducted by various central banks have tried to understand the reasons for the phenomenon, known as the “paradox of banknotes”. Given the widespread use of digital payments substituting for cash, one explanation for this apparent paradox is that the demand for cash is driven mainly by precautionary motives. This gets exacerbated during periods of crisis, most recently the Covid-19 pandemic.
In India, a similar paradox occurs. The expectation that the shock of demonetisation would lead to lower demand for cash has been belied. If anything, the demand has increased. The currency in circulation is currently around Rs 32,000,00 crore compared to Rs 17,000,00 crore at time of demonetisation. The cash-to-GDP ratio is around 12%, about the same level as it was in November 2016. It had even gone above 13% during the pandemic.
Strong demand for cash
At the heart of the paradox is the question about why there is a strong demand for cash. Studies have shown that similar preference for cash was observed in several countries in Europe and the UK especially during the pandemic. But motives and demographics are a bit different form India. In Europe, cash is preferred mostly by older people who are intimidated by technology, while in India there is both a rural-urban division and an economic divide. The informal sector, which employs a substantial part of the labour force and the rural economy are predominantly cash-dominated while urban middle- and upper-income groups have gravitated to digital and online payments. Beyond economics, there is a mystique about physical currency that cannot be easily substituted by numbers on the ledger or the computer.
Among the bank notes, the demand is clearly for higher denomination notes. There is some evidence that digital payments using third party mobile apps such as Paytm, debit and credit cards and Unified Payments Interface have taken a substantial share of retail payments in urban areas. This has led to a substantial decline in demand for smaller denomination especially of Rs 50 and less. The share of the recently introduced Rs 200 remains small.
The note most in demand is Rs 500 with Rs 100 as a distant second. The Rs 500 note is the lynchpin of currency in circulation as it simultaneously satisfies both the transactions demand and precautionary demand, as a store of value.
The Reserve Bank has done well to give adequate time and hopefully better arrangements to facilitate the exchange of the withdrawn notes. But it is still possible that many including the old, poor and those living abroad may miss the opportunity to exchange their currency by the announced deadline. Perhaps the Reserve Bank could have done even better by emulating the European Central Bank, where the 500 euro note is being gradually withdrawn. The note remains legal tender and is likely to be withdrawn over a much longer time horizon. This is despite the fact that at least 40% of higher 500 euro are held outside the euro zone. The public has full confidence that the notes in their possession will be redeemed on demand. Indeed, even now, the notes of the defunct Deutsche marks and other currencies can be exchanged for euros in the offices of the central banks long after the euro was adopted in 1999.
Importance of public confidence in a sovereign currency cannot be overstated. The solemn promise to repay the face value of the currency note was not honoured for thousands of small holders of demonetised bank notes in India in 2016. A repeat of this, even on a much smaller scale, will have adverse consequences, both domestic and international.
Any short-term economic or political benefit would be trivial in comparison to the long-term erosion of trust and faith in the currency. For a currency aspiring to become an international reserve currency, and for the implementation of a digital currency, this could be a serious setback. The Reserve Bank and the government should carefully evaluate their next moves taking these factors into account.
Kaushik Jayaram is a former central banker who worked for many years in an international financial organisation.
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