In November 2016, Prime Minister Narendra Modi announced that 500 and 1000 notes were no longer legal tender and needed to be exchanged for new currency, thus withdrawing 86% of the cash in the Indian economy. The cash crunch that followed had a significant adverse impact on the informal sector in particular, which predominantly uses cash for transactions and depends largely on informal cash credit.

In recent weeks, reports of currency shortages have emerged from several parts of the country. The government is attributing the cash crunch to “unusual" high demand for currency, while maintaining that there is sufficient cash supply for normal transaction demand.

At the outset, it is important to point out that one cannot say anything about this situation with certainty due to a lack of required evidence. As with any commodity, the shortage appears to be a demand-supply mismatch. The Reserve Bank of India (RBI) data shows that between January and March, currency with the public (demand for money), in absolute terms, increased from Rs16,328.2 billion to Rs17,599.7 billion. A 7.8% jump over a three-month period would be considered quite substantial in normal circumstances but seeing that it is only in February that the pre-demonetisation level of currency with the public (Rs17,013.8 billion) was crossed, the entire period since November 2016 up until now is one of remonetization.

Now, if we look at the ratio between currency with the public and reserve money (total supply of money in the system), it was 0.75 in March, which is the highest it has been in the remonetization period so far, but still lower than pre-demonetisation (0.77 in October 2016). Currency with the public can either be hoarded, or used for informal sector transactions. If there is indeed cash hoarding, as is being speculated, then a possibility is that the low ratio is explained by a slowdown in the informal sector. Thus, there is a need to disentangle the various demand and supply components. Let us consider some of the elements at play.

Demand and supply dynamics: Right after demonetisation, the RBI concentrated on printing 2000 notes, in an attempt to quickly remonetize a large sum of money. People tend to keep some precautionary cash at home, in higher-denomination notes, and without 100% digitization of transactions in terms of acceptance and feasibility, one cannot label this need as entirely psychological. Given that demonetisation wiped out these reserves, people would have had to begin accumulating new notes all over again. In fact, the uncertainty created by demonetisation may have caused them to want larger reserves than before.

There would have been similar pent-up demand for cash held for illicit purposes. If anything, 2000 notes can be used more conveniently as “store of value" vis-à-vis the old 1000 notes.

Hence, the new currency being printed was not just being used for normal transaction purposes but also to meet demonetisation-induced extra demand for currency.

Further, the absence of 1000 notes and the delay in widespread availability of 500 notes after demonetisation reduced the utility of 2000 notes for day-to-day transactions. Non-compliance with the “1-2-5 formula" for currency could have led to 2000 notes being hoarded rather than circulated in the economy, as change was hard to come by.

Essentially, this is all high-denomination new currency that has not been coming back to the banks.

Various explanations are being put forth for the current increase in currency demand. The most credible of these is the election story because the observed cash crunch is in the vicinity of states that are going to poll. Also, given the uncertainty around cash availability since demonetisation and the Uttar Pradesh election fiasco, it is likely that political parties would want to keep their chests filled up beforehand.

On the other hand, a “bank run" due to the “bail-in" clause in the Financial Resolution and Deposit Insurance (FRDI) Bill or the Punjab National Bank scam, seems rather unlikely because of the geographical specificity of the shortage. Finally, the excess demand for cash is also being attributed to the agricultural harvest season. However, we are not in the peak of the selling period yet; this is not a bumper-harvest year; and it is in the sowing season that more cash is required by the sector.

ATM run: Of late, the central bank’s focus has shifted to printing 200 notes (and other smaller denominations) but not all ATMs have been re-calibrated to dispense them. Even if all ATMs are re-calibrated, there are physical constraints on the number of notes of each denomination that an ATM can hold. So, if it is the small note trays that are filled up more than the big note ones, the total amount of money in ATMs would be lower. Assuming that the usage of ATMs remains the same, the machines would need to be replenished more frequently, which is an additional cost for banks and may not be viable. If some ATMs go out-of-use every now and then, people would be prompted to withdraw more than they need—when they can—and hoard cash, putting further pressure on ATMs.

In conclusion, the current cash crunch does seem to be temporary and should be resolved once the demand-supply mismatch is addressed. What may persist is the ATM issue and it is important to examine it.

Nalini Gulati is managing editor, Ideas For India. She gratefully acknowledges valuable inputs by Pronab Sen.

Published with permission from Ideas For India, an economics and policy portal.

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