Why Is Currency In Circulation Rising Despite Soaring Digital Transactions? HSBC's Pranjul Bhandari Explains

India has seen a rise in digital payments, specifically through the unified payments interface route, which saw monthly transaction rise to over Rs 10 lakh crore in May.

Despite this, currency-in-circulation in the Indian economy remains high. In fact, it has been rising once again since the start of 2022.

Why is that?

Traditionally, rural demand has been a key driver of currency in circulation. But this time around real rural wages are falling. But inflation raises the demand for cash in hand to meet regular expenses.

According to HSBC economists Pranjul Bhandari, Aayushi Chaudhary and Priya Mehrishi, rising inflation could be responsible for about 40% of the increase in cash demand.

Something else is at play, the economists wrote in a note on Friday.

A key factor driving up demand for cash, according to them, could be the state of the informal sector.

"India’s large informal sector has suffered back-to-back blows in recent years. We believe that the distress in the informal sector is pushing it increasingly towards cash-based activity, especially those activities that end up falling outside the tax net," the HSBC economists said.

While the Covid-19-prompted lockdowns in 2020 severely hampered their business, they were slowly on the path to recovery. Even before they could recover, the sharp rise in commodity products this year has hurt this sector further.

"Small firms are not as energy efficient as large ones and don’t have as much bargaining power in the market for inputs. As a result, small and informal firms have been losing market share, and their profitability has been hurting," HSBC economists said.

Typically, smaller companies cut salaries as a way to manage their expenses, which is visible in falling real rural wages. However, after a point in time, these companies also avoid taxes and move to cash-based activities, the economists said.

One may ask why goods and services tax collections are rising, if cash-based activity has increased? The HSBC economists note that a growing formal economy can co-exist with higher stress in the informal sector.

Besides, when scaled to gross domestic product growth, the rise in GST revenues is not that impressive. In fact, had the informal economy not been under stress, the GST revenues would have grown faster, the economist said.

The rising cash in circulation may end up becoming a silver lining for the Reserve Bank of India, which is trying to drain system liquidity in its bid to control inflation.

It also provides some space for the RBI to pursue other goals such as facilitating non-disruptive government borrowing over the year. As fiscal pressures mount, the government is likely to run a fiscal deficit that, HSBC economists estimate, will be Rs 2 lakh crore more than budgeted. The rise in currency in circulation leakage may help the RBI to buy bonds without significantly adding to outstanding liquidity.

The economists did raise a note of caution though. If the ongoing rise in currency-in-circulation comes on the back of informal sector distress, it needs to be addressed, they said.