The paradox of banknotes: understanding the demand for cash beyond transactional use

Prepared by Alejandro Zamora-Pérez

Published as part of the ECB Economic Bulletin, Issue 2/2021.

1 Introduction

A phenomenon referred to as the “paradox of banknotes”^[1] has been observed in the euro area; in recent years, the demand for euro banknotes has constantly increased while the use of banknotes for retail transactions seems to have decreased. Recent payment surveys indicate that the share of cash transactions in the euro area has decreased. This, together with ongoing digitalisation in retail payments, might have been expected to lead to a decrease in the demand for cash.^[2] However, this reduction in demand has not occurred. In fact, the number of euro banknotes in circulation has increased since 2007 (see Chart 1). This seemingly counterintuitive paradox can be explained by demand for banknotes as a store of value in the euro area (e.g. euro area citizens holding cash savings) coupled with demand for euro banknotes outside the euro area. This article will use the available evidence to explain this phenomenon in more detail.

The growth in circulation of euro banknotes has been strong since they were introduced, even when considering the ratio of euro banknotes to GDP, or to the broad monetary aggregate M3.^[3] This growth in circulation has intensified during the coronavirus (COVID-19) pandemic. At the end of 2020, the value of euro banknotes in circulation amounted to €1,435 billion, increasing by 11% from €1,293 billion in 2019 (Chart 1). Due to the COVID-19 pandemic, this annual growth rate was exceptionally high when compared with previous years (5% annual growth in the past 10 years on average). The only time the growth rate was higher was during the months following the Lehman Brothers collapse in September 2008.^[4] However, the growth of euro banknote circulation has been remarkably strong since they were introduced even when compared to some other macroeconomic magnitudes; for example, the ratios of euro banknotes to nominal gross domestic product (NGDP) and to M3 have increased over the years (see Chart 2), amounting to 10.83% and 9.94% at the end of 2019, respectively. This suggests there are unique determinants behind the high demand for euro banknotes, other than the development of the activity of the domestic economy (NGDP) and distinct from factors influencing other monetary assets/liabilities (M3).

Understanding the drivers of increasing banknote circulation is important for central bank core activities such as cash and liquidity management, retail payment strategies and monetary policy. Central bank cash and liquidity management activities can be improved by a good understanding of the demand for cash. For instance, if cash is widely used as a safe haven during times of potential market turbulence, it may be mandatory to hold substantial strategic contingency stocks of banknotes to meet extraordinarily high demand during periods of crisis.^[5] Furthermore, understanding the demand for cash can shape well-informed retail payment strategies, for example by enabling projections for the future use of means of payments, or even assessing the potential demand of a cash-like central bank digital currency (CBDC). In addition, the size and growth of some components of cash demand have relevant implications when assessing the monetary policy stance and its implementation in a low interest rate environment.^[6]

To shed light on the paradox of banknotes, it is important to identify the main uses of banknotes, although this is a difficult endeavour because cash usage is mostly unobservable. The value of euro banknotes in circulation can be broken down into three components: the value of banknotes (a) held for domestic transactions, (b) stored domestically and (c) demanded outside the euro area (both for transactions and as a store of value). Estimating the size of these components is key to understanding the paradox of banknotes. However, making such estimations is a highly complicated process because cash is used anonymously. The data collected by the European Central Bank (ECB) refers only to flows of banknotes through the central and commercial banks, so only a small part of the cash cycle is observable. There are also grey areas where it is impossible to define when a banknote is held for transactions or as a store of value. Nevertheless, it is possible to learn about the different uses of banknotes through direct (i.e. surveying cash users) and indirect approaches. These will be explored in the present article in Sections 2 and 3. Section 4 will address the COVID-19 developments during 2020, remarking on the importance of cash during crises.

2 Transactional use of cash in the euro area

Estimates of the value of banknotes held for transactions in the euro area can be produced using indirect approaches but these are subject to limitations. Indirect approaches use available ECB data on euro cash coupled with a set of assumptions to produce estimates of the portion of the value of banknote circulation used for domestic transactions. However, the reliability of these methods depends on the particular assumptions employed, and therefore they should be considered with an appropriate level of caution. The following looks at three approaches: (i) the seasonal method, (ii) the return frequency method and (iii) an analysis of the issuance of the Europa Series (i.e. the second series of euro banknotes). These provide insights as to the size and nature of domestic transactional demand for banknotes.

The seasonal method indicates that in 2019 between 13% and 30% of the value of banknote circulation was held for the purpose of euro area transactions, yielding a central estimate of 21.5% (€280 billion). The share of banknote circulation used for euro area transactions can be estimated using the seasonal method.^[7] This method exploits the strong monthly seasonality of banknote demand to divide total circulation into domestic transactional demand and the rest of the demand components (domestic store of value and foreign demand). This means that estimates of this decomposition are produced by comparing the seasonality of total banknote circulation with the seasonality of a benchmark variable that is purely transactional.^[8] As the reliability of this method strongly depends on the benchmark, two series were selected to produce an upper and a lower bound. Results indicate that, in 2019, between 13% and 30% of the value of euro banknote circulation was used for transactions in the euro area (see Chart 3). The central estimate of 21.5% (€280 billion) is considered to be a good approximation^[9] but should still be interpreted with caution. It is also worth noting that both benchmarks indicate that the share of circulation used for domestic transactions has decreased over the years.

According to the return frequency method, in 2019 between 15% and 25% of the value of euro banknote circulation was held for transactions in the euro area, yielding a central estimate of around 20% (€260 billion). Different denominations of euro banknotes return to Eurosystem central banks at varying frequencies.^[10] Banknotes returning less often are partly circulating in domestic channels more distant from central banks and partly stored domestically or held abroad. As with the seasonal method, it is possible to produce an upper and lower bound of the active circulation by using the return frequency of purely transactional denominations as benchmarks (making two extreme assumptions). This is narrower than the interval estimated using the seasonal method.

An analysis of the introduction of the second series of euro banknotes provides further information on how the different denominations of banknotes circulate. The introduction of the second series of euro banknotes and the subsequent replacement of the first series provides valuable information. The saturation rates of different banknote denominations (i.e. number of banknotes of the second series in circulation over total number of banknotes from the first and second series) follow a specific type of pattern which can be analysed by fitting curves to the data.^[11] Chart 4 illustrates this for €5 (typically transactional, like the €10 and €20 denominations) and €50 denominations (used for transactions but also as a store of value domestically and abroad like other high value denominations €100 and €200). An interesting pattern emerges: the curves start flattening before the new series saturate 100% of the circulation, reaching a steady-state saturation rate called the “carrying capacity”. This means that a portion of banknotes from the first series may never return to the Eurosystem because they may be either permanently stored domestically or – as is perhaps more likely – lost or held abroad. For low (typically transactional) denominations one would expect that most banknotes return to the central bank. They exhibit a higher carrying capacity (around 86% and 89%) than higher-value denominations (for example, the €50 has a projected carrying capacity of 70%). Also, as one would expect, the €5 denomination (mostly used for transactions) has a steeper curve, meaning that it reaches the carrying capacity quicker than the €50 (used for transactional purposes but also as a store of value both domestically and abroad).^[12] These patterns are also observable with other denominations. This shows that the higher the value, the higher the likelihood that a banknote is used as a store of value domestically or abroad; similarly, the higher the value, the higher the likelihood it is held as a store of value for a long time.

A recent ECB household survey^[13] shows that the total value of cash transactions by citizens in 2019 amounted to €1,993 billion and that cash is still the most used means of (retail) payment, although the share of cash payments has decreased. Although indirect methods can provide valuable estimates of the use of cash for transactions domestically, direct methods such as payment surveys are necessary to supplement our indirect knowledge. As explained in more detail in Box 1, the cited ECB survey shows that, in 2019, cash was the most used means of payment in the euro area for point-of-sale (POS) and person-to-person (P2P) transactions and non-negligible in other types of transactions. However, the share of cash payments has decreased in the past three years by six percentage points. According to the survey, euro cash has been used for 117 billion physical and online transactions, corresponding to a value of €1,993 billion.

3 The non-transactional demand of banknotes

The central estimates of the previous section suggest that around 80% of the value of banknotes in circulation was not actively used for domestic transactions in 2019, and this share has risen over the years. The following section will present the available evidence on the remaining components of cash demand, namely foreign demand and domestic store of value.

The circulation of euro banknotes outside the euro area

A recent comprehensive study^[18] on the foreign demand for banknotes suggests that between 30% and 50% of the value of euro banknotes was held abroad in 2019 and this share has been increasing in recent years. In December 2019 the total cumulated (i.e. net) euro banknotes shipped in and out of the euro area via banking channels only represented 13% of total banknote circulation in terms of value. However, the study clarifies that there are several channels through which banknotes can flow in and out of the euro area, such as non-registered remittances or tourism. This is why several indirect approaches were used to more accurately investigate this topic. According to a method developed by the ECB, in 2019 around 30% of the total value of banknotes in circulation was held abroad.^[19] This share goes up to 50% for the same year when using the seasonal (estimates for 2018) and age of banknote methods (estimates for 2019). These two methods compare certain characteristics (such as seasonality or the lifespan of banknotes) of the euro banknote population with other, otherwise similar, reference countries’ banknote populations.^[20] Interestingly, both the ECB method and the seasonal method^[21] suggest that this share has been increasing over the years (from around 20% in 2008 to around 30% in 2018 and from over 35% in 2008 to over 50% in 2018, respectively). The wide interval resulting from the different methods reflects the complexity of estimating the size of the foreign demand component of euro banknotes. As explained in relation to the indirect approaches used in Section 2, the reliability of these methods depends on a variety of assumptions, and thus the results should be taken with a certain degree of caution.

There are many reasons why in developing and transition economies there is a high demand for national cash in general and foreign strong currencies in particular.^[22] The literature normally attributes the high use of cash in developing and transition countries to both supply-side problems (such as underdeveloped payment infrastructures and the lack of access to credible saving alternatives) as well as demand-side factors (lack of trust in banks, deeply entrenched habits or unfavourable perceptions towards electronic payments). For the use of US dollar outside the United States, it has been found that some of the factors that influence its foreign demand are high historical inflation in those countries, size of the domestic market, global and local economic uncertainty and past dollar use. Recent evidence from a survey conducted regularly by the Oesterreichische Nationalbank (OeNB) also provides valuable findings on the determinants of euro banknote demand, although it is limited to central, eastern and south-eastern European economies. These determinants include limited trust in the local financial systems and in local currency, stronger individual preferences for cash, or expectations of the future adoption of the euro.

A macroeconometric model of euro banknote demand and quantitative and qualitative analyses of the determinants of euro net shipments find that mostly local factors (from countries demanding banknotes) influence foreign demand.^[23] Different approaches indicate that the local economic activity of foreign countries has an impact on the overall demand for euro banknotes; also, local inflation, local unemployment and the nominal USD/EUR exchange rate influence euro net shipments. The influence seems to be mainly driven by medium- and high-denomination banknotes. Notably, apart from store-of-value and safe-haven asset demand, in some regions (Americas, Middle East, Asia and western non-EU countries) tourism seems to be the most important factor influencing demand.

The use of euro banknotes for domestic store of value

Between 27.5% and 50% of the value of banknote circulation is thought to be stored in the euro area in 2019, meaning that per-adult cash reserves (of euro area citizens as well as of banks and companies) range between €1,270 and €2,310. Using the estimates that around 20% of the value in circulation was used for domestic transactions and between 30% and 50% was held abroad, this means that in 2019 between 27.5% and 50% was used for store-of-value purposes in the euro area.^[24] This implies that the amount of cash reserves per-adult ranged between €1,270 and €2,310. It should be stressed that this per-adult amount includes people’s holdings, but also cash held by euro area monetary financial institutions (MFIs) and companies. This breakdown by sectors has not been determined so far.

Although cash held by MFIs in normal conditions is mostly held for transaction purposes, the developments of vault cash in recent years can provide a hint of the amount of cash used for store-of-value purposes. Generally, MFIs hold cash in their vaults mainly for the purpose of transactions. Chart 5 shows that, after the rate of the ECB’s deposit facility went into negative territory (more obviously, when it was decreased in March 2016 from -0.3% to -0.4%) a visible break in the series can be observed, hinting that storing cash was made relatively more attractive. As vault cash was rather stable from 2009 to the moment when the deposit facility rate first became negative in June 2014, it is likely that most of the €30 billion (60%) increase from then until the end of 2019^[25] was for the purpose of storing value. Despite its pronounced increase, vault cash only represented around 7% of total banknote circulation at the end of 2019 so it can by no means entirely explain the increase of domestic store of value usage.

In contrast to MFIs, there is neither available data on the precise amount of cash held by retailers and citizens, nor estimates on the trends of their cash holdings in recent years. At the same time, it is certain that the above change in the deposit facility rate did not affect companies (who mostly hold cash for transactions) and people living in the euro area in the same manner as it did MFIs, as neither people nor companies are able to deposit excess liquidity with the ECB. Nevertheless, as long as the opportunity cost of holding cash has decreased due to the low interest rate environment, people and companies might have been inclined to save more in cash than in other liquid assets yielding low interest. However, it is likely that, as is the case with other currencies that experienced a high increase in non-transactional demand, the low interest environment cannot fully explain the rise in demand. It is possible that other factors, such as increased uncertainty or the ageing of the population, may be at play.^[26]

Household surveys, such as SPACE, provide further evidence on cash reserves held by citizens but, due to the sensitivity of the questions, respondents are thought to underreport their cash holdings. This means that survey results must also be considered with an appropriate level of caution. Box 2 presents evidence from SPACE on cash reserves, as well as from a recent nationwide survey in Germany studying the motives of why German citizens save in cash.

4 The increase in banknote issuance during crises: the case of the COVID-19 pandemic

During 2020 the increase in banknote circulation was abnormally high due to the COVID-19 pandemic, a trend that has also been observed in other crises periods. During different types of crises, people tend to increasingly demand cash, and the COVID-19 crisis was no exception (see Box 3). Chart 6 shows the net issuance of euro banknotes in 2020 and compares it with the previous two (normal) years. After the negative issuance at the beginning of the year (when, after Christmas, returned banknotes are always higher than issued banknotes), net issuance in 2020 started deviating from the normal growth rate once the COVID-19 pandemic spread across Europe. In the two previous years, net issuance in December was around €61 billion, while in 2020 it was over €141 billion (an €80 billion difference representing an increase of over 130%).

The transactional demand for cash has decreased while contactless payments have increased, according to a 2020 ECB survey on consumers’ perceptions during early stages of the pandemic. The survey to measure the impact of the pandemic on cash trend (IMPACT survey) provides an indication as to changes in payment behaviour during the first stages of the COVID-19 pandemic^[30]. Although around half of the respondents reported using cash and cards in a similar manner as they had before the crisis, around 40% declared that they were using contactless payment cards more often. The same share (40%) of respondents declare that they were using cash much less often or somewhat less often. The latter group of respondents were also asked about their expected behaviour after the pandemic; around 87% indicated that they would continue to pay less often in cash when the pandemic is over. This would point towards a further decrease in transactional demand for cash, although researchers have observed that consumer perceptions or self-reported preferences are normally not indicative of payment behaviour.^[31] Hence, further survey evidence after the pandemic is needed to assess whether these findings will be consolidated after the pandemic.

Reduced banknote flows in and out of Eurosystem central banks indicate that active circulation has decreased, suggesting a higher precautionary demand possibly due to increased uncertainty and reduced mobility^[32]. Although during other crises there was an increase in the gross issuance of euro banknotes, during the COVID-19 pandemic it decreased compared to previous levels. The high increase in net issuance (gross issuance minus returns) is because the number of banknotes returning to the central bank decreased even more than gross issuance. This indicates that banknotes are circulating less actively than in the previous year, reflecting an impulse to keep cash reserves for precautionary savings, as well as corroborating a weaker transactional demand. Reasons for this behaviour could include increased uncertainty and reduced mobility (leading households to hold higher amounts, thereby reducing the need to go to a cash dispenser).

Euro banknote shipments data suggests that foreign demand did not account for a sizeable share of this increase, which indicates that it could be mostly due to precautionary motives within the euro area. The cumulated net shipments of euro banknotes abroad in 2020 was negative, meaning that more banknotes returned from abroad than those that were issued. This indicates that demand for banknotes from outside the euro area did not contribute to high demand. Informal channels, such as tourism or remittances, most likely did not contribute either, as these activities also decreased during the pandemic. This means that most of the demand was coming from domestic (euro area) precautionary savings.

5 Conclusions

The first step to understanding the paradox of banknotes is to acknowledge the importance of demand for cash for store-of-value purposes, as well as demand for euro banknotes outside the euro area. Although cash is still the most used means of payment at POS and P2P according to recent ECB surveys, the share of cash transactions versus other payment methods has decreased over time. However, cash demand has increased overall, and decomposing banknote circulation into its three components (euro area transactional demand, store of value inside the euro area and foreign demand) is key to explaining this increase. The share of the value of banknote circulation held for euro area transactions is thought to be between 20% and 22% (the upper and lowest bounds indicate this share may be between 13% to 30%, but these are based on extreme assumptions and central estimates are deemed reasonable). This reduced share highlights the importance of the other two components of cash demand: the store-of-value demand inside the euro area (28% to 50% of total circulation value in 2019) and the foreign demand for euro banknotes (30% to 50% in 2019). The wide intervals of the estimates indicate a high uncertainty due to the fact that the ways people actually use cash is not directly observable. This means that such estimates should be considered with appropriate caution. Figure 1 depicts the estimated size of the different components of banknote demand.

The COVID-19 pandemic has intensified the euro area demand for cash for precautionary purposes (i.e. as a store of value) while the transactional demand seems to have further decreased; it is still uncertain how cash would be used after the pandemic. Survey evidence and the reduced flows of banknotes in and out of the Eurosystem central banks suggest that the demand for cash transactions has decreased. As with other crises, the increase in cash demand has been driven by precautionary motives, although this demand has come mainly from inside the euro area. Further evidence will be needed in the future to assess how cash will be used once the pandemic is over.