Can the ‘paradox of banknotes’ ever be reversed?
Digital payments are rising. But so is the demand for cash.
Money – in one form or another – has been around for the last 5,000 years of human history. From cowrie shells and whale teeth to coins and paper notes, currency has evolved so much over a fascinating few millennia that it is now unrecognisable.
The advent and widespread uptake of digital payments in the 21st century is expected to render paper notes redundant. After all, digital payments in India alone grew 64% and 23% in volume and value respectively during 2021-2022. In 2022-23, these numbers stood at 58% and 19% respectively (admittedly, the pandemic spurred these numbers on).
But, there is reason to believe that cash is here to stay.
Before we go ahead, I’d like to share that we are hosting a webinar where a panel of experts will discuss the future of the AA framework, from the perspective of Technology Service Providers and Financial Information Users.
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What leads to CiC growth?
Despite the spurt in digital payments, the currency in circulation (CiC) – the total number of banknotes and coins – is showing no signs of decline. Before we dive into the significance of this, let’s unpack the trends and factors behind fluctuations in currency demand over the last few decades.
1969-1980: Nationalisation of banks and bank branch expansion led to a hike in CiC from 8.4% to 14%.
1986-1995: High inflation and nominal GDP growth, along with the balance of payments crisis led to another spurt in CiC growth.
1996-2001: The dip in CiC growth during this period can be attributed to the focus on price stability through monetary contraction.
2001-2009: Economic revival resulting from first and second generation reforms led to another growth during this period.
2009-2016: CiC growth fell again following the Payment and Settlement Systems (PSS) Act in 2008 which led to the proliferation of alternative payment modes. The Jan Dhan-Aadhaar-Mobile (JAM) combine as well as steps taken under the Digital India scheme explain the decline from 16.9% in 2008 to 9.5% in 2016.
2016-2021: The developments over the previous period had a more or less sustained effect on the growth of CiC. This explains why the pandemic-induced peak in 2020 still fell short of the pre-PSS Act in 2008. The surge during this period can be attributed to remonetisation after 2016 and the subsequent pandemic restrictions.
2021- present: The long-term growth in CiC is now showing signs of ebbing. The peaks and dips are both slowing reducing, possibly indicating stability owing to an uptake of digital payment methods.
‘The paradox of banknotes’
Now that we have a clearer picture of the trends in CiC growth, let’s circle back to why it is surprising – or at least counterintuitive – that this growth has sustained despite a rise in digital payments.
CiC serves as a proxy for cash-based transactions, but if people increasingly use digital payments, what accounts for the demand for cash?
India, like many other economies, is experiencing a phenomenon labelled ‘the paradox of banknotes’ by Andrew Bailey, Governor of the Bank of England. This means that even though cash serves little transactional purpose, the value of notes in circulation continues to rise.
What has caused this paradox? I previously wrote about how the lack of trust could explain this. This week, I’d like to delve into the reasons given by the RBI and how innovation can help curb the demand for cash and redirect the population towards digitisation. While policy-level changes can effect real changes in transaction patterns, cash demand, and drive digitisation - technological innovation can catalyse these actions.
Demand deposits
Demand deposits form the foundation of digital payments. They are the funds deposited in bank accounts that can be withdrawn on demand. However, when deposit rates are low, account holders are more likely to turn to cash as a store of value.
There exists a wealth of FinTech platforms that can nudge users to deposit more by making the process smoother – by making account opening easier,, through auto- and micro-saving features, cashback and rewards programs, gamification, and consolidation and comparison tools.
Moreover, digital public infrastructure like the Account Aggregator framework is helping regulated and non-regulated financial institutions to come together and enable innovative use cases in savings, among several other financial services.
Informal economy
Large chunks of the MSME segment and unskilled and gig workers continue to transact in cash. By some estimates, the informal and unorganised sectors make up nearly 40% of the Indian economy.
This has spawned an entire industry committed to bringing these segments into the formal fold of the economy with FinTech solutions— lending, bookkeeping and accounting, microfinance, invoicing, supply chain solutions, and countless other use cases. Such digitisation would lay the groundwork for higher demand deposits, and ultimately, give a fillip to innovation and formalisation. .
Direct benefit transfers
In 2020-21, the total cash-based direct benefit transfers rose 24% to 27 crore beneficiaries, compared to 12% in the previous year. In fact, Rs 56,849 in DBT made up 14% of the total variation in CiC in 2020-21.
Digitisation of delivering direct benefits in partnership with tech players is nothing new. The introduction of Aadhaar and biometric authentication reduced leakages in the last-mile delivery of government benefits.
Several payments banks with a robust digital arm are working towards the smooth delivery of direct benefit transfers leveraging their vast network and digital infrastructure. This, combined with large-scale schemes like PMJDY, will help build bank deposits, and as a result, digital transactions.
Precautionary holdings
Financial savings of households made up 15.5% of the Gross National Disposable Income in 2020-21. In the year-ago period, this was 11.7%. Benefit schemes during the pandemic, deferral of loan repayments and decline in consumption expenditure are some reasons that could explain the increase in household savings.
Because deposits and currency holdings continued to rise during this period, it can be inferred that cash was being used as a saving tool in times of uncertainty. Take a look at the share of banknotes in circulation based on their denomination:
High denomination notes formed 44% of the total notes in circulation in 2022-23, compared to 21% in 2010-16! In terms of value, these banknotes made up 90% of the notes in circulation. (The Rs 500 banknotes are ubiquitous due to the withdrawal of Rs 1,000 notes and moderation of the Rs 2,000 banknotes).
Wide circulation of small denomination notes would denote that cash is being used for transactions, but the growth of higher denomination banknotes confirms the use of cash as a store of value.
Conclusion
The ‘paradox of banknotes’ could be explained by the fact that the substitution effect in this case is overshadowed by the income effect that explains the demand for cash despite a rise in digital transactions. By all means, this is a positive sign for an emerging economy like ours.
And even though the digital mode of storing value and transacting will abate the effects of this income effect, tech players will remain critical in redirecting a cash-enamoured population towards digitisation.
That's all from me this week!
Cheers,
Rajat