New Delhi: What caused the unusually high rise in cash available with the public in fiscal 2016, the highest in five years? Public statements by former RBI governor Raghuram Rajan and State Bank of India (SBI) chairperson Arundhati Bhattacharya, as far back as April 2016, indicate that markets were abuzz with the likelihood of demonetisation.

An April research report from the SBI’s economic research department (which disclaims that its views do not necessarily reflect that of the bank’s) and a RBI circular on Rs 100 notes a week before Prime Minister Narendra Modi’s speech were two concrete signs of the impending demonetisation.

The back-and-forth between Rajan and Bhattacharya started in early April. In comments to the media, Rajan pointed out that the “high year-on-year rise in currency in circulation in fiscal 2016 could be because cash with the public goes up close to polls”.

“You can see that there is a spike not just in the state going to polls but also in the neighbouring state. There is something there and we need to understand it better,” Rajan added.

Rajan’s logic here was that in the past, in the years of 2003-04 and 2011, there had also been a rise in currency available with the public just before major polls, with much documented (if anecdotal) evidence of how parties woo voters with cash payments.

Bhattacharya, however, did not agree with Rajan’s argument. “We’ve seen even bigger elections in earlier years but the increase in currency with the public has not been that high. This time it is hurting our deposit growth and, after a long time, our deposit growth is less than advances,” Bhattacharya was reported to have said. She further added that “the reason for the cash surge was still a mystery” and ruled out possible impact of the jeweller’s strike earlier this year.

Moving towards safe haven assets

In doing so, the SBI chairperson implicitly endorsed a SBI ecowrap report – authored by SBI chief economist Soumya Kanti Ghosh – whose primary thesis was that the increase in cash with the public was not driven by state elections but rather the “trend in demonetisation”.

“The common perception is that FY17 being an election year people are hoarding cash. However, had this been true, even FY14 should have shown the similar trend. In fact, that year witnessed a decline,” Ghosh and his team wrote in the report’s opening remarks.

“The bigger reason,” the report noted, “could be the trend in demonetisation”. “There are suggestions in public domain and even analysis that are suggesting that higher denomination notes may be replaced. We believe, as a result of that people may be using more of high value currency to purchase safe haven assets (emphasis added).”

The report then went on to analyse the advantages and disadvantages of demonetisation, and the numerous “logistical challenges” that could emanate from such a move. Crucially, the report bases its analysis on the fact that both Rs. 500 and Rs 1000 notes would be demonetised – a move which the RBI and Modi government would take six months later.

What are the advantages of demonetisation, according to the SBI report? It would “bring a huge amount of the funds kept in these denominations into the banking channels and will facilitate a reduction in domestic black money transactions”. Another implicit advantage proposed was that it would push people into shifting “towards electronic modes of payment thereby making it increasingly easier to track financial transactions, thereby leading to better service tax and income tax collections”.

The SBI’s chief economist and his team also ran through the logistical nightmares that would follow demonetisation – challenges that we are currently seeing throughout the country.What would happen? According to the report, firstly the capacity of the Indian banking system’s currency chests would need to be “expanded 5x”. The report noted:

“Currently there are around 5000 currency chests across the country with the Banks that are used for storing notes. The capacity of these chests would need to be expanded 5x to enable storing of enough supply of currency to the public. Construction of these chests- which have specialized steel walls and doors, would take time, as well as, substantial investment.”

ATM chaos

This explains, along with India’s poor printing capacity, the slow choking of India’s cash supply currently being seen.

The report also presciently identifies the chaos that demonetisation would cause at India’s ATMs. Back in April 2016, ATM operators had told the SBI that demonetising “Rs 500 and Rs 1000 notes would throw up huge challenges as ATM machines will hold lesser amounts than their current capacity. An ATM machine typically holds 10,000 bills and if these were to comprise only notes of `100 the rate of replenishment would go up. This will increase costs and inconvenience to customers.”

Ghosh and his team even ran through scenario analysis on how often ATMs across India would need to be replenished. In his example, outlined below, he assumed that the new note that would be introduced would be a Rs 5,000 denomination and not the Rs 2,000 note that was finally introduced.

“A hypothetical scenario analysis in which in lieu of Rs 500 and Rs 1000 denomination currency notes, Rs 5000 denomination notes are introduced so that 100 and 5000 rupee notes contribute 2/3rd and 1/3rd of the total value in circulation shows that the ATM replenishment frequency still increases to 3.57 times per day (a high transaction ATM which runs out of cash once a day will fall short of currency several times a day,” the report notes.

Market analysts pointed out to the The Wire that while the introduction of Rs 2000 notes and not Rs 5000 notes should theoretically reduce the ATM replenishment rate, the general trend of people being averse to withdrawing the new Rs 2000 notes and the short supply of the new Rs 500 notes indicate that the ATM replenishment rate needed today is far greater than 3.57 times per day.

RBI circular

Another solid indicator of the Modi government’s impending demonetisation move was a RBI circular put out on November 2, a week before the decision was actually announced.

The circular said that in order to ensure that the “genuine requirement of members of public for Rs 100 denomination banknotes are met”, a pilot project would be conducted where 10% of all ATMs across the country would be calibrated to “exclusively dispense Rs 100 banknotes”.

Curiously, the RBI had given banks 15 days to complete this exercise – which multiple sources say is the reason why the central bank too might have thought demonetisation would have come later in December.

The RBI’s circular crucially came on the back of a review that it had conducted “on the steps taken by banks for installing ATMs dispensing lower denomination bankotes”. In this review, the central bank found that only a handful of banks had paid heed and set up ATMs that specifically dispensed Rs 50 and Rs 10 notes.

The RBI circular, however, was not taken seriously by most banks and ATM manufacturers, The Wire was told by banking and industry observers.

“Rumours of demonetisation and even scenario planning was there with regard to the demonetisation move. While the RBI circular one week before demonetisation raised some signals, it was not acted upon. Not too many within the banking industry and ATM industry took it seriously as you can see now with the chaos that grips India,” a senior banking official, who declined to be identified, said.