Flatten the (cash) curve

Hard cash holding in Pakistan is amongst the highest in the world. This means informal economy is big. The cash in hand was always high in Pakistan; but the curve of CIC/M2 (currency in circulation to monetary aggregate) has steepened ever since the tax on cash withdrawal was imposed on non-filers in July 2015 (from FY16). M2 is largely a sum of bank deposits and CIC.

Increased efforts of documentation and high interest rates could not attract the cash holdings in the formal banking system. In fact, the incremental CIC in Jul-Apr this year is more than double of the same period last year. The cash went out of the system this year is almost equal to the size of Meezan Bank’s deposits. There is huge opportunity cost of high cash, government and central bank have to work on undoing this.

Currency in circulation (commonly known as cash holding) is usually at a certain level in any economy. The rest of the money is held in bank deposits – directly or indirectly. The ratio of CIC/M2 in developed world is around 5-7 percent. In India, the ratio used to be 14 percent prior to demonization (Nov-2016) and it fell to 10 percent in 2017 before rising it back to 14 percent. This shows demonetization did not really work in India.

In Pakistan, the ratio was around 23-24 percent prior to the banking transaction tax in FY16. The ratio thereafter increased and there is no stoppage to this date. It increased to 27 percent when the PTI government came in power. Thereafter, the efforts to documentation accelerated and the interest rates increased. Higher rates along with PKR depreciation, increased the opportunity cost of cash holding. But the ratio kept on increasing and the curve has steepened. The ratio has broken the psychological barrier of 30 percent. This could well be the highest in the world.

There are certain demerits of such high cash holdings. The money is not part of the system and is largely insulated to monetary policy decisions to curb or boost demand. The velocity of money (GDP/money supply) becomes low. In modern day economics, money is created by issuing new loans. If a bank issues a loan, a matching amount of deposit is being created in borrower’s account. Banks issue loans on existing deposits. If the deposit base is low (because of high CIC), the money creation process decelerates. The money stagnates in case of cash holding.

SBP has to work on flattening the curve of CIC. In absolute amount, CIC has reached Rs5.8 trillion in April 2020. In the last ten years, it has increased by over 5 times. Not to mention foreign currency cash holding and prize bonds are other than this. The SBP needs to do a study on finding the reasons for this abnormal hike. One proposal is to do away with cash withdrawal tax of 0.6 percent for non-filers. The agenda is also pushed by the IMF and is likely to happen in this budget.

But will this be enough? May be not. The cost of documentation is too high for the cash holder. They have forgone 13 percent plus interest rate. Either the money is making better return through informal lending (or investing in informal business) or the cost of making the cash formal is too high. One thing is for sure that the money is not responding to government’s fear. One way is to give some sort of amnesty – one of such in construction sector is in offing.

The other reason could be that the bank deposit is largely demand liabilities (CASA) and not time liabilities. In India, time deposits are 7 times of demand deposits. In Pakistan demand deposits are 20 times of time deposits. The current is flowing in entirely different direction in Pakistan. Banks are focusing on low cost deposits. This needs to change. When banks are making huge spreads by not passing on benefits to consumer, it is hard to attract cash holdings.

The SBP can use digital channels to enhance banking deposit penetration along with providing comfort to cash holders to document the money. The stick is clearly not working. Time to bring on the carrots.