Currency Increase & De-Monetization
SEVEN months before actual demonetisation, the State Bank of India's Economic Research Department had warned about the possible fall out of the Demonetisation, in its magazine "Ecowrap" on April 07 2016. This is what the Research Team said,
Cash with public has increased notably. The common perception is that FY17 being an election year people are hoarding cash. However, had this been true, even FY14 should have shown the similar trend. In fact, that year witnessed a decline. Also in FY12, when Punjab and Uttar Pradesh went to polls, currency in circulation actually witnessed a significant decline. Does this mean that elections in Punjab and Uttar Pradesh are relatively more transparent than say other states like Bihar (reason for possible increase in currency in 2015)?
We believe election may be only a small reason, but the bigger reason could be the trend in demonetization. There are suggestions in public domain and even analysis that are suggesting that higher denomination notes may be replaced. We believe, as a result of that people may be using more of high value currency to purchase safe haven assets.
This apart, there has been an increased overdraft of nearly Rs 170 crores that has been provided by the banks to the PMJDY account holders which may also be responsible for this sudden spurt in currency.
However, demonetization if is being contemplated, a road map needs to be created. It needs to be done in steps and be balanced with creation of necessary electronic and digital infrastructure in the country coupled with creating awareness and financial literacy for ensuring that the man on the street is not put to undue hardship.
THE ADVANTAGES & DISADVANTAGES OF POSSIBLE DEMONETIZATION
There has been suggestion that is doing the rounds that higher denomination notes of Rs.1000 and Rs.500 be demonetized. This is expected to yield the following benefits:
++ Demonetizing Rs.500 and Rs.1,000 currency notes will bring a huge amount of the funds kept in these denominations into the banking channels and will facilitate a reduction in domestic black money transactions.
++ As holding cash in small denominations is cumbersome, the informal services payments made in day to day life, people will shift towards electronic modes of payment thereby making it increasingly easier to track financial transactions, thereby leading to better service tax and income tax collections.
However, should we accept this logic, we need to take a hard look at the logistical challenges that will emanate.
First of all - demand for banknotes and coins increased in FY15, notwithstanding the use of technology driven non-cash modes of payment.
Notes of denominations of Rs.500 and Rs.1,000 together accounted for approximately 85% of the total value of banknotes in circulation at end March 2015.
Despite the presence of high denominations, RBI had spent Rs.37.62 billion in printing notes in 2014-15. If the notes of these two denominations are withdrawn, the cost of printing notes for RBI would also multiply.
At the branch level, the cost of handling cash would zoom and there would be complete chaos as the funds kept in these denominations will be flushed into the banking channels.
Operators of automated teller machines say that demonetizing Rs.500 and Rs.1,000 notes will throw up huge challenges as ATM machines will hold lesser amounts than their current capacity. An ATM machine typically holds 10,000 bills and if these were to comprise only notes of Rs.100 the rate of replenishment would go up. This will increase costs and inconvenience to customers. Besides, transaction time at machines would also rise because maximum amount that can be withdrawn at one go would be Rs.4,000 since machines are designed to dispense only 40 notes at a time.
Along the entire supply chain for supply of cash, banking system will bear the highest cost primarily because of high fixed costs of ATM machines, counting, recounting, recycling, transport and storage of larger volumes of cash.
SCENARIO ANALYSIS
If the Rs.500 and Rs.1000 denomination notes are removed, in order to maintain the same amount of liquidity, the number of other denomination notes will have to be increased. A hypothetical scenario analysis in which in lieu of Rs.500 and Rs.1000 denomination currency notes, Rs.5000 denomination notes are introduced so that Rs.100 and Rs.5000 notes contribute 2/3rd and 1/3rd of the total value in circulation shows that the ATM replenishment frequency still increases to 3.57 times per day (a high transaction ATM which runs out of cash once a day will fall short of currency several times a day. This is so because cash replenishment agencies will take a couple of hours to respond, customers will be affected because of the downtime). The costs also shoot up by Rs.15 billion.
CONCLUSION
++ The news of the demonetization of currencies of denomination 500 and 1000 has been doing the rounds for a while, and this may be a plausible reason for increase in currency with public. The rationale for this is that people are taking out cash and buying other assets such as gold so that when the currency is demonetized they do not face a problem.
++ Our considered view, therefore, would be that should demonetization be seriously contemplated, a road map needs to be created. It needs to be done in steps and be balanced with creation of necessary electronic and digital infrastructure in the country coupled with creating awareness and financial literacy for ensuring that the man on the street is not put to undue hardship.
Apparently, the powers that be did not take the State Bank Research Team seriously.