Tuesday, February 27, 2024

The Butterfly Effect in Cash Circulation: How Small Details Help Central Banks Fulfill Their Strategic Roles

“Cash helps to stabilize the economy,” reads a research paper by the German Technical University of Applied Sciences, adding that “it should be the undisputed task of central banks to ensure that cash remains in circulation in normal times and is provided in a fully elastic way in times of crisis.” And indeed, supporting cash circulation is critically important for the entire financial system of a country, and even minute details are of enormous importance. What can happen if one cog in this system fails?  

Central banks are never idle. Working as the monetary system regulators, they have plenty of strategic roles, one of which is to serve as the provider of fiat currency. Here, they assume a critical position in regulating the supply of cash in circulation, ensuring that sufficient amount of currency is available to meet the needs of the economy without oversupplying the market.

What happens when this function falters? Let’s look at the case of India, which in November 2016 unexpectedly announced withdrawal of most of its cash. The goal was to end corruption, counterfeiting and kill a large shadow economy, and Indians would have to exchange or deposit their large rupee bills in a matter of weeks. While the locals floundered in panic, the Indian Central Bank was shipping in new types of bills to the roughly 600 districts in the country. The new banknotes were sent to districts at different speeds and in different batches, which resulted in cash shortfalls and caused a 2-percentage point crash in economic growth during the first few months after the policy was announced. Seven years later, the calm and slow withdrawal of the 2,000 rupee note shows that the country’s Central Bank learned its lesson in necessity of keeping the cash circulation stable.

When slow speed makes the economy stumble 

“If India had been able to print those notes and distribute them instantaneously, there wouldn’t have been any problem,” says Gabriel Chodorow-Reich, an economist at Harvard University. This statement emphasizes the importance of coherence between those responsible for making the nation’s monetary system work and their helpers, the cash printing and handling industry. Should one link in this chain crumble, the consequences can be devastating, as evidenced by the example above and by the situation from the point of view of Swiss-based security printing solutions provider Koenig & Bauer Banknote Solutions (KBBS), who holds over 90 percent of the world security printing equipment market: “Emerging markets need increasing amounts of cash, as cash in circulation closely correlates with gross domestic product,” noted KBBS’s Chief Financial Officer.”

The smooth operation of the entire system helps central banks fulfil their strategic role of providing fiduciary services. The nature and stages of ensuring the cash in circulation follow a seemingly simple logic: print, dispatch, return worn-out banknotes. A deeper look, however, reveals an integral ecosystem. At the heart of it is the constant need to optimize and tailor all processes in order to organize short yet efficient circuits, suitable for different situations and different cash centers and depots.

“There is no standard cash center that can simply be lifted and shifted to the next customer. Every cash center has specific needs – including those determined by local or internal rules,” says Hermann Gessler, Head of Technical Sales and Consulting, Value Added Solutions and Services, at German security printing and solutions company G+D. A simple example of such a center is cash-in-transit companies (CIT) specializing in the secure and efficient transportation of cash and valuables, bridging the gap between financial institutions, retail businesses, and the public. They collect cash from retail outlets, banks, and ATMs, deliver it to secure processing centers for sorting, counting, and bundling. Their work is well-orchestrated normally, but sometimes unexpected cruces occur.

Why low cash production quality affects everyone  

The work of CIT companies and all other cash handlers directly supports central banks’ efforts to maintain an efficient and universally available cash cycle. It is clear in our next example from Australia, where several banks have sold some of their off-branch ATM fleets to third-party operators, and the country’s central bank granted CIT companies a regulatory exemption with the goal of providing cardholders with wider access to fee-free ATMs. All these actions were taken with one big goal: to provide access to banknotes in remote areas in conditions of reduced demand for cash and, consequently, lower profitability of the ATM infrastructure. One of the problems was the unpleasantly high cost of replenishing machines with banknotes as the transport cost grew higher with the distance. To address this issue, banks and CIT companies have resorted to the use of ATMs with banknote recycling capability. This, in turn, cut expenditures – but with a potential trade-off of having lower-quality banknotes as they are not processed at CIT cash depots as frequently.

One of the central banks’ requirements for cash, namely to ensure the reliability and quality of banknotes, directly relates to solving similar problems. The quality of banknotes in circulation is inevitably deteriorating but the better they are printed, the more they remain readable. Essentially, the requirements for print quality and materials serve as a benchmark for security printing works, explains Thomas Savare, CEO of French fiduciary printer Oberthur Fiduciaire: “Integrated security technologies, the lifespan of the banknote and its composition are so important factors. This corresponds to the intrinsic characteristics of the banknote, its qualities as an object.”

To make these requirements work, banks and security printers enlist the help of another industry players, i.e., suppliers of specialized equipment and materials. The quality of the banknotes produced plays a major role in this, says Eric Boissonnas, CEO of Swiss-based security printing solutions provider Koenig & Bauer Banknote Solutions: “In a developing country, the cost of circulating banknotes is around 70 times higher than the cost of producing them. However, this ratio rises to 200 times the production cost in highly developed countries, where the life cycle is far more complex. Hence the importance of producing banknotes that are as durable as possible, while complying with cash cycle requirements.” Among other things, the quality here is ensured by specialized equipment with very precise tolerances, he adds: “[The high quality and precision] enables the banknotes to be authenticated several hundred times, at lower cost, while reducing the need for secure transport and the associated environmental impact.”

How weak circulation can cause economic collapse 

Beyond the day-to-day functioning of the economy, the strategic role of central banks and their assistants extends to ensuring access to cash in all circumstances, whether in remote areas, when changing banknote series or in times of crisis. Interestingly, the importance of this role does not depend on the economic condition of a country, and equally applies to a developing cash-dependent state like India and the economically country like the USA in our next example.

The case of the United States at the height of the COVID-19 pandemic is of particular interest as it shows how a disruption in a miniscule detail such as a coin circulation causes a ripple effect on the entire economy. By the middle of 2020, the first year of the pandemic, the US monetary authority discovered a severe shortage of small coins in the country. Then, the lockdown mandate to shut down businesses reduced the coins circulation, while the US Mint cut production. The resulted “Great Coin Shortage” caused monetary rationing, difficulties paying bills, businesses losing revenue, weaker general economic growth and impacts on unbanked people.

Setting to resolve the crisis, the US Mint had to restart production and increase its volume. This measure helped to boost the number of coins in circulation, but did not solve the problem completely. Stepping forward to help, businesses employed promo campaigns, with some fully switching to digital payments, with nothing helping much as the primary issue lied in unusual circulation disruption, explained the US Coin Task Force member Hannah L. Walker: “The weak circulation affects most everyone, but the hardest hit are small cash-dependent businesses and those who are least well off. For millions of Americans, cash is the only form of payment.”

Now that the issues in the US, India and other countries are mostly over, the delicate interdependence of all players in the fiduciary services provision becomes all the more evident. The speed of cash distribution, production subtleties, control and coordinated work of all participants enables central banks to perform their currency provider function effectively. What’s more, the cases above reveal the immense impact of this function on other facets of the economy and society, from financial stability and implementation of monetary policies to social support measures and general safety and soundness of private and business transactions – and makes us think about the butterfly effect, where bad print quality, a speed too slow, or a coin sitting in a jar may result in a great economic collapse.

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