Editor’s note this was authored last week before the recent bank woes in India
Prime Minister Narendra Modi was elected to take big, transformational decisions. In his address to the nation yesterday late evening, he took the country by storm with his announcement to make Rs 500 and Rs 1,000 notes untenable as legal tender post-midnight on 8 November, 2016. It is the third round of demonetization done by GoI post 1946 when the notes of Rs 1,000 and Rs 5,000 and 1978 when the notes of Rs 1,000, 5000 and 10,000 were demonetized in an attempt to curb black money and inflation.
Presently, 86% of outstanding currency value in circulation is being demonetized which is a significant step towards the transition to a non-cash economy. Cash in circulation in India is 12% of GDP or 16% of bank deposits – this is too high (in China this is 4% of bank deposits). RBI mentioned that there are 16bn Rs500 notes and 6.7bn Rs1000 notes in circulation currently, which means that Rs14,700bn worth of cash currency is in Rs500/1000 denomination notes.
And everything was pre-planned systematically…let’s connect the dots…
During 2011-16, total notes in circulation grew by 40%, while Rs500 notes increased by 76% and Rs1000 notes by 109%, indicating surge of counterfeit in high denomination notes
? To curb black money and make Indian economy with more of digital cash and minimal black money, government initiated GST, Pradhan Mantri Jan Dhan Yojna, DBT etc. Also, factually, 87% of the population is covered under Aadhaar and 20% of the population has PMJDY accounts
Could this move have been timed better?
Demonetization move comes right after voluntary income declaration scheme (IDS) is closed (Rs1.2 trillion recovered), giving government space to impose heavy penalties and taxes on black money that would be recovered now
On the other hand, if this had been announced in advance it could have been self-defeating in nature; allowing holders of black money to convert their cash for gold or other forms of wealth instead. The secrecy surrounding this decision – coming as it did as a shock to common man, policy and even most government circles – only reaffirms this.
In the immediate term, cash liquidity in the large parts of the economy will freeze temporarily, till the new notes are fully introduced. we see significant impact on economic activity as initial two months maybe possibly disruptive in several supply chains.
It will be hurtful to the rural economy in the near-term, where a large proportion of transactions are still conducted using cash.
There could be permanent wealth destruction of Rs3tn if 20% of these notes are not exchanged which could impact inter-personal lending, real-estate, jewellery and banks with such exposure.
From a funds flow perspective, households’ physical savings are around US$270bn (13% of GDP) while financial savings are US$160bn (7.7% of GDP). Therefore, this will positively impact the share of financial savings within the economy in the longer term as households could reduce their allocation towards physical assets like gold and property.
All in all, this would be more than outweighed in the medium term by the positive impact on improved transparency and tax compliance (tax revenues) significantly and consequently benefit public finances.
No Pain, No Gain…is the proven story of common man
Starting 9th November, Rs 500 and Rs 1,000 notes would be deemed illegal for trade. Common man can exchange/ deposit old currency notes for next 50 days (till 30th December 2016). Post 30th December 2016, a person will still be able to exchange old notes till 31st March 2017, with furnishing an appropriate ID card at RBI nodal offices.
While there is no limit on depositing this cash in bank accounts, exchanging cash would be limited to Rs 20,000 per week and Rs10,000 in a day. This would limit the cash which is simply exchanged and would put pressure on people to deposit money in bank. Withdrawal limit is set at Rs 2000 per day and Rs 4000 per week starting 10th November.
Eventually, this will increase bank’s deposits base as currency with public comes down and will also make lending cheaper as interest rates will come down. But this will happen slowly, not over-night.
Inflation will undershoot RBI’s medium-term target of 5% inflation, resulting in 50-75bps rate cuts in next 6-9 months.
Between there will be significant impact on the sectors which are dependent on cash transactions…..
There will be considerable impact on the Real Estate sector, land prices could see sharp fall, creating chaos initially but in a long-term this will bring middle class back in the market thus curbing the highest ever inventory build-up in India’s real estate market.
Jewellery sector will see negative repercussions due to amount of black money destruction.
For all MFIs and some NBFCs, their cash collections could be meaningfully disrupted, if not resolved quickly, could temporarily lead to asset quality pressures. They may need some regulatory forbearance in judging which accounts are genuinely stressed and which only have a liquidity problem.
Banks in the near-term will be negatively impacted as there will be concerns over SMEs and LAPs loans as they may become unviable. Although in the long-term it is positive as the CASA deposits will go up significantly improving formal money channels.
Few other sectors which will see negative impact include cement, metals (steel specifically), FMCG, consumer durables, companies into building materials.
Keep in mind the longer-term picture for the economy, this is a strong and bold step taken by the government to curb the black money; however the ripple effects of this cannot be understated. There are major industries in India thrive on a parallel economy funded by black money. How will this affect the more legitimate and normal economy? The weeks and months ahead will tell.
But not to forget as stated by the Prime Minister himself, “There is a need for a decisive war against the menace of corruption, black money and terrorism… Corruption, black money and terrorism are festering wounds which make the country hollow from within.”
Disclaimer: The views expressed in this article are personal in nature. It do not construe to be any investment, legal or taxation advice. Any action taken by the reader or recipient on the basis of the information contained herein is reader’s/recipient’s responsibility alone and Tata Asset Management Limited will not be liable in any manner for the consequences of such action taken by reader / recipient.