Why is currency in circulation in India rising?

There were flurry of articles towards end of India’s financial year on this murky term – currency in circulation. All these articles (article one , two and three)were looking at possible reasons for sharp rise of currency in circulation.

The question is why should anyone care? Well, one sees this circulation rising in times of high inflation as people need more money to settle transactions. But with declining inflation, one should not see a rise in the currency numbers.

First what is this Currency in circulation? This is basically all the paper notes we carry in our pockets. This along with rupee coins and small coins with RBI form currency in circulation. Rupee coins and small coins in the balance sheet of the Reserve Bank of India include ten-rupee coins issued since October 1969, two rupee-coins issued since November 1982 and five rupee coins issued since November 1985.

Next, what is the problem? See this table:

As we can see currency in circulation has increased by nearly 48% year on year in 2015-16 and 34% in 2014-15. The growth in 2014-15 was also on account of a deceleration in currency growth previous year by 11%.

This is large growth especially when we look at falling inflation numbers. :

The recent increase in currency with the public is confounding economists, as by the numbers it seems the citizenry is hoarding cash in a falling inflation climate. At a time when a majority of Indian households hold a bank account, after the Pradhan Mantri Jan Dhan Yojana, the preference to keep cash handy could be a strong indication of a booming consumer sector but that largely is not the case. Generally, cash in circulation should increase when prices are on the rise at a faster clip and should fall with a slowing of inflation.

“However, with inflation on the decline and under control… the question is whether such a high currency demand basically reflects uncertainty about the prospects of the economy,” State Bank of India Chief Economist  Soumya Kanti Ghosh wrote in an article in this newspaper on March 23.

Currency in circulation at the end of 2015-16 on Thursday had risen 15.7 per cent to Rs 2,26,630 crore from Rs 145,080 crore a year before, a rise of Rs 82,000 crore. The growth was 11.2 per cent a year before. Yet, Consumer Price Index-based inflation was 5.18 per cent in February, down from 5.69 per cent in January. The Reserve Bank of India’s own target is to contain inflation below four per cent in the medium term, which economists say is achievable.

Any increase in currency in circulation points to a leak in the banking system, as otherwise cash gets deposited with the bank, which goes for investment. Currency in circulation does rise during the festive season around October but by the end of the financial year, the situation normalises. This time it hasn’t happened and nobody is sure why.  

First, all this talk of low inflation is plain non-sense.  There are two inflation numbers – one tracked by policymakers & analysts and another faced by people. The latter is always some 4-5% higher than official estimates.

Second, lower inflation does not mean prices have declined. All it means is rate of growth has become lower compared to last year. SO if inflation was 10% last year and 5% this year, it means prices are continuing to rise. They are actually higher than last year prices. But both policymakers and media misguide people most of the time suggesting lower inflation means lower prices. People have to pay even a higher amount for their basket of goods. If one adds unofficial inflation to the official figure, it implies people will continue to need more cash to settle their transactions.

Third, all kinds of reasons have been given like elections, changing behaviour due to ATMs and so on. No one has looked at source of the problem. Currency in circulation does not rise on its own. It is basically an outcome of central bank policy. In this case, it is the continuous boosting of forex reserves which has led to rise in this currency in circulation.

Let me explain.

Currency in circulation are liabilities of the central bank balance sheet. On assets we have government securities and foreign securities as the main assets of a central bank. In a central bank balance sheet there are many non-monetary liabilities (like reserves, profits etc) which form part of liabilities and present a misleading picture. So, we have something called reserve money which subtracts these non-monetary liabilities from the liabilities to present a truer picture. This reserve money is also called as base money or high powered money in textbooks. See this primer for more  details prepared by your truly ages ago.

Simplifying things further, the remodeled balance sheet has liabilities as components and assets as sources. This helps one understand things directly.  There are other components and sources as well, but we just include these three as they constitute most part of the balance sheet nowadays.

Components of Reserve Money Sources of Reserve Money
Currency in Circulation Govt securities
  Foreign govt securities

Hence, source of rise/decline in currency is mainly these two sources – one’s own govt securities or foreign govt securities. Call it a sin of an emerging market central bank but it prefers to have more of foreign govt securities in their balance sheet which is also called as forex reserve. Whereas the developed world central banks mostly have their own govt securities in their balance sheet as we have also seen in QE etc by these banks.

So whatever source central bank chooses to push, it shows in currency in circulation. It is nothing but simple accountany – assets = liabilities.

In India’s case as forex reserves have risen in last few years sharply, so has currency in circulation. The share of Indian govt securities has been declining as can be seen from this table:

  Growth number (year on year)
  Currency in circulation G-sec Foreign Assets
Mar-16 15.7 13.1 11.5
Feb-16 13.7 2.7 14.3
Jan-16 12.7 -9.4 16.5
Dec-15 13.0 -22.5 15.4
Nov-15 13.5 -19.2 20.1
Oct-15 10.9 -22.0 19.5
Sep-15 11.8 -20.2 20.4
Aug-15 10.4 -12.4 20.7
Jul-15 9.6 -7.1 16.8
Jun-15 10.2 -33.1 20.2
May-15 10.7 -36.8 22.6
Apr-15 11.2 -32.2 16.3
Mar-15 11.2 -44.3 17.8
Feb-15 10.7 -35.7 15.7
Jan-15 10.5 -29.1 13.0
Dec-14 9.6 -19.0 11.5
Nov-14 8.5 -15.4 8.8
Oct-14 9.2 -20.1 12.6
Sep-14 11.0 -21.5 13.7
Aug-14 11.2 -19.4 7.2
Jul-14 11.8 -21.2 17.9
Jun-14 11.6 -2.1 12.7
May-14 11.2 3.8 14.3
Apr-14 9.5 1.6 18.1
Mar-14 9.1 7.8 15.6

So, currency in circulation is not the cause but actually an outcome of a central bank policy. This is the first step in any analysis looking at rise in currency in circulation. It is first an accounting entry which we then use to draw economic inferences.

In earlier times, this accounting variable could be used to draw economic inferences as things were relatively controlled by central bank. There was a reason why we had something called money supply targeting where money supply was the tweaking variable. Soon, central banks relaised they had little control over this given financial innovations and flow of money across borders. So they stopped targeting money and moved to interest rates. In famous words of a central banker (from Canada I think) ” We didn’t leave money, it left us”.

Hence, it might not be right to just draw inferences from this number alone. It could be a lot more complicated and we need more data to understand currency usage in India. The currency numbers are not in line with broad reality, tells you the same thing as well..

4 Responses to “Why is currency in circulation in India rising?”

  1. Shekhar Midthanpally Says:

    So what is the case like
    1. Did RBI buy foreign assets to infuse more currency into system?
    or
    2. Were foreign currency assets increased due to any other factor?

    In the case, if RBI was buying Foreign assets, why din’t RBI report loss on balance sheet instead of increasing foreign currency assets?

  2. manasiecon Says:

    Hi Amol, I think I’d like to interpret this a bit differently than what you’re doing. First, I agree with you that currency in circulation has increased in response to the increase in FOREX reserves. But that is the “supply” of currency in circulation.

    What is baffling economists is why the “demand” for currency has risen..

    This implies that even when the supply of C increases, the demand for C is higher, which is manifested in higher call rates, CBLO or any other yield movements.

    The money demand normally responds to inflation, interest rates, GDP growth, level of usage of plastic money etc. Now, in the last couple of years, plastic usage is up, inflation rates have been normal. Money supply in fact has been rising due to FOREX, and yet one finds that the money demand is up more than that which is being supplied.

    This indicates as you’ve correctly pointed out, to a leakage in the banking system.

    What do you say?

    My Best and Appreciation always,
    Manasi.

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