Hype Around Cash-To-GDP Ratio Misses Critical Nuances

After the currency exchange announcement of November 8, 2016, branded as demonetisation, economic analysis came out thick and fast. Over the following two weeks, as the currency exchange evolved into a scheme intended to push India towards being a ‘cashless’ economy, another burst of analysis came out about India’s currency-in-circulation to gross domestic product (CIC-to-GDP) ratio. Before a quick reduction of the CIC-to-GDP ratio becomes a national economic priority, on the lines of boosting infrastructure or reviving growth, it may be worthwhile to understand the nuances associated with this ratio.

When Is Cash ‘Too Much’?

In economics, we must be wary of making sweeping statements like higher GDP growth is always better than lower GDP growth. When inflation is surging, some may prefer lower GDP growth. Sensible policy makers and influencers have this nuanced understanding since GDP is a well-studied measure. Likewise, they have much better (if not perfect) understanding about what constitutes an unsustainable level of inflation or national debt.

In comparison, the CIC-to-GDP ratio is not that well researched. It may be wise to be circumspect before drawing any hasty conclusions about the correct level of the CIC-to-GDP ratio for India. There also needs to be caution about the optimal speed with which this ratio needs to be reduced without affecting the economy, and the steps that will be required to achieve this objective.

While noting that a sharp rise in the CIC-to-GDP over a short period of time may be worrisome, there is limited understanding of what constitutes a ‘high’ or ‘worrisome’ or ‘unsustainable’ level that must trigger policy action.

Getting perspective on the ratio itself, possible factors driving the value of the ratio, and the relevance of cross-country comparisons may be helpful in encouraging an informed debate on the issue. This piece is an effort in that direction.

A Global Comparison

The Committee on Payments and Market Infrastructures - Bank for International Settlements (CPMI-BIS), which calculates this ratio annually, considers currency-in-circulation (CIC), basically bank notes and coins, and divides it by nominal GDP. To enable cross-country comparison, the local currency is converted to the U.S. dollar at an average exchange rate. So, cross-country analysis of this ratio done over a period gets affected by the trajectory of the exchange rate in relation to the dollar.

For India, the latest CIC-to-GDP ratio is 12.25 percent. Despite the rise in the ratio from 2013, this is not the highest India has seen.

Possible factors driving up the ratio are:

• Sequentially lower nominal GDP growth between 2013 (13.9 percent) and 2015 (8.7 percent)
• A spike in the value of CIC during the period

Some concern regarding the uptick in the CIC-to-GDP ratio is understandable. However, it is not clear whether addressing this (if at all that has been the objective of demonetisation) must take precedence over other macro issues such as a falling investment rate, a lukewarm economic recovery or burgeoning banking system bad debt.

Use And Abuse Of Comparisons

Ever since a disparate group of economies with different economic fundamentals was clubbed under the BRICS acronym, comparing any ratio across the BRICS economies has become an analytical ritual. Continuing with the ritual, the recent analysis observed that Brazil, South Africa have much lower CIC-to-GDP ratios than India. The fact that Russia’s ratio is comparable to India may have been inadvertently neglected.

It is difficult to conclude whether a lower CIC-to-GDP ratio is a sign of a more developed or structurally evolved economy. If it is, then how does one explain countries such as Japan, Hong Kong, Switzerland having ratios which are either higher or comparable to that of India? The World Bank ranks these countries higher on ease of doing business, as well as tax and regulatory compliance.

Structural Drivers Of Cash-To-GDP

Applying correlation - to be always applied with caution - one may actually observe a small negative correlation between the tax-to-GDP ratio and the CIC-to-GDP ratio.

There may be some truth to the assumption that higher tax compliance tends to reduce the CIC-to-GDP ratio. To that extent, efforts already underway such as the implementation of the Goods and Services Tax (GST) would be beneficial.

Sweeping statements are avoidable since Brazil, India, Canada and the U.S. have a comparable tax-to-GDP ratio but divergent CIC-to-GDP ratios.

Another driver of CIC-to-GDP may be penetration of payment institutions and bank branches. The steps India has taken in the last couple of years on financial inclusion and improving the payment infrastructure, given time, may have been beneficial is in bringing down the ratio.

The point here is that the CIC-to-GDP ratio, by itself, may be of limited significance. A lowering of that ratio may be associated with improving structural features of the economy, such as improved tax compliance and financial inclusion. Such structural improvement takes time. This ratio may also be driven by social and cultural aspects. As such, attempts to reduce the CIC-to-GDP ratio by merely reducing currency in circulation without the necessary structural reforms may have unintended consequences.

Demonetisation’s biggest benefit may be in terms of the message it sends out to tax evaders which says that bold steps could be taken to widen the tax net. The country would be supportive of such measures despite the pain. But suggesting that reducing the CIC-to-GDP ratio through demonetisation would help that process is akin to suggesting that liposuction is a solution for medical obesity.

Deep Narayan Mukherjee is a financial services professional and visiting faculty of finance at IIM Calcutta.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.