Tuesday, June 27, 2023

For the first time ever, euro paper money in circulation is shrinking

Why is the paper euro shrinking? Are we at peak cash

To begin with, here is the data, charted: 

As the orange line shows, Europe is experiencing its first year-over-year drop in paper money in circulation. 

While it's tempting to attribute this to paper money's declining role in payments, what I suspect is happening is that as the European Central Bank hikes interest rates, Europeans are redepositing spare cash into the banking system so that they can earn yield. And the net result is less cash in circulation.

Just twelve months ago, the ECB's key interest rate was still in negative territory, sitting at -0.5%. At the time, holding a bit of extra cash under a mattress didn't hurt anyone, since there was no interest to be earned by returning it to one's bank. Then, in four swift moves beginning in mid-2022 (July 27, September 14, November 2, and December 21), the ECB jacked up rates to 2%. As of today its deposit rate is at 3.5%.

Suddenly, owning large chunks of cash under one's mattress had an opportunity cost. Queue a mass reverse bank run, one which involved bringing 0% paper money back to banks, and then to the ECB, in order to convert it into interest-earning assets.

One the best examples of this is from European banks themselves. To satisfy customer withdrawal requests, banks typically keep a reserve of banknotes on hand in their vaults. Historically they've always tried to minimize this stock, since they couldn't earn any interest on notes. But this urge to minimize holdings evaporated with negative interest rates, as the chart below shows. Banks let their vault cash double in size from 2014 to 2020.

When interest rates finally jumped from negative territory back to 0% in late July 2022, the opposite happened. As the chart shows, banks rapidly emptied their vaults and brought their banknotes back to the ECB in order to convert them into central bank deposits, even though those deposits only yielded 0%. Paper money incurs storage costs, so banks will generally prefer a 0% deposit, which doesn't incur storage costs, to a 0% banknote. And now that deposits at the ECB are yielding 3.5%, there's just no contest. Paper money is out, digital money is in.

We can get a broader picture of the rush to redeposit notes by looking at the European Central Bank's banknote flow data, illustrated below. Every month, banks withdraw notes from the ECB (orange line) and return notes to the ECB (blue line), in order to satisfy the public's demand for cash. Banks generally withdraw more notes than they redeposit, the net result being the steadily rising stock of paper currency that we see in the top-most chart. 

On the heels of the ECB's July 27, 2022 rate hike, the ECB experienced its highest rate of note redeposits in almost ten years, coming in at 106 billion in August. Much of that would have been the aforementioned banks returning some 40 billion in vault cash to the ECB. But banks wouldn't have been the only large actors to empty their mattresses.

European retailers probably let themselves get sloppy after 2014, holding a lot of extra cash in their store tills and safety deposit boxes rather than depositing it only to earn a negative return. With rates now positive, these retailers are probably being much more vigilant in sweeping up all spare company cash and redepositing it to the banking system. Other likely culprits include investment companies who, rather rather than holding negative yielding bonds, opted to store as many banknotes as possible, and are now changing their investment strategies.

In sum, the paper euro is shrinking, but it's probably due to higher interest rates, not fewer cash payments. Nor is this peak cash. After an interest rate-induced pause, the upwards rise in paper euros in circulation will probably continue.


  1. Replies
    1. Ugh, sorry, meant to post ^this^ on your Bitcoin /Binance ETF analysis.