Demonetisation will result in near-term pain for long-term gains
The evening of 8 November 2016 will be remembered in India as the day of a surgical strike on black money. Prime Minister Narendra Modi announced demonetisation of old currency notes of Rs500 and Rs1,000 denomination with immediate effect, in an effort to stop the counterfeiting of high-value currency notes allegedly used for funding terrorism. He also wanted to crack down on the huge volume of unaccounted black money in the country.
The move holds great significance, considering the size of unaccounted economy in the country. In the near term, it is bound to cause pain and discomfort but, in the long run, the country is expected to emerge stronger and more prosperous because of it.
Indians are used to making their transactions in cash, propelling a parallel economy. Cash contributes to a large chunk of their spending too. The practice of using plastic money is still low in India, when compared to developed countries. With the growth of e-commerce and banking system, the trend is swiftly changing towards formal banking channels, e-wallets and plastic money. With this demonetisation move, the trend is expected to gather more pace.
Currently, there is huge uproar from the people because of the hardships faced by them while converting their old currencies into new ones – such as standing in queues for long hours, etc. There is a vacuum created due to the severe shortage of liquidity. This is causing psychological pain, affecting the spending pattern. People are deferring purchases of big-ticket items and are spending only on essentials. This is bound to severely curtail demand in the economy – more so, for discretionary items, till the entire transition phase is completed.
The demonetisation drive is expected to change the dynamics of Indian economy. Of the total Rs17 lakh crore worth of bank notes in circulation, some 86 per cent (about Rs14 lakh crore) is in the denominations of Rs500 and Rs1,000. The demonetisation drive may wipe out a good 25-30 per cent of the total high value notes in circulation (say, Rs4 lakh crore), currently unaccounted, reducing the RBI’s liability and creating windfall gains for the central bank, which may in turn pay a one-time special dividend to the government. India’s fiscal deficit stood at 3.9 per cent of the GDP (Rs5.3lakh crore) for 2015-16. If the RBI declares a one-time special dividend to the government, it may wipe off a large part of the fiscal deficit. Also, there will be a sharp rise in tax revenues, as unaccounted cash gets channelised into the banking system.
As old currency notes come to banks for conversion, bank deposits will shoot up in the near term, mainly in the form of low-cost CASA deposits. Even assuming that a sum of Rs4-5 lakh crore gets withdrawn by the public, going forward, the remaining amount would still be with the banks, for lending to the formal economy.
Reduction in the quantum of liquidity from the system is expected to affect demand in the near term. Inflation will fall, setting the stage for rate cuts by the RBI. Lower interest rates will propel growth of the formal economy too. Bond yields in India have already started falling after the announcement of demonetisation.
The increase in liquidity in the banks has started reflecting on deposit rates offered by banks to their customers. Most banks have started cutting interest rates by up to 100 bps on bulk deposits.
The demonetisation drive has also set the stage for a bumper budget in February 2017. The government may even cut tax rates and make huge budgetary allocations to boost the economy. Most economists have hailed the government’s decision as historic, as it will lead to structural changes. However, this transition from unaccounted cash to formal economy will not come without pain. It will take its toll on near-term business prospects. There will be a sharp fall in demand, till sufficient liquidity is created. The pain will continue for at least the next few quarters, till the whole process of demonetisation is complete. The government has also hinted at more rigorous steps to bring black money holders in to its net. All this will affect near-term sentiment for the markets. Real estate and gold have become unattractive asset classes for fresh investments.
The structural changes to the economy will make India’s growth story certain, making a strong case for investments into equities. Long-term savings will also start flowing into equities. So much so that India is bound to get re-rated and emerge as the bright shining star. Equity investors over the long term are all set to reap huge benefits from equities.
This article was originally published in Business India Magazine.
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