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Demonetization
Event Update
The World Bank in July, 2010 estimated the size of the shadow
economy for India at 20.7% of the Gross Domestic Product (GDP) in
1999 and rising to 23.2% in 2007. Assuming that this figure has not
risen since then (quite unlikely though) and that the cash component
of the shadow economy is also proportional (it could be higher), the
estimated unaccounted value of the currency could be to the tune of
Rs.3.3 trillion. Now, post the announcement of demonetization by
the government this money would have to either account for by
paying the relevant tax and penalties or would get extinguished.
There are higher chances of larger proportion of this unaccounted
currency getting extinguished as the tax rate and subsequent legal
issues could be prohibitively high for such money.
The positive macro benefits of this move by the
government
This move by the government is likely to have long term benefits for
the economy. The extinguishing of the major proportion of
unaccounted currency would reduce from the liabilities of the
government and would add to its finances. This can have very strong
implication as the government would get money to spend without
borrowing from the market. This would mean that while interest
rates can be low, the government spending on large infrastructure
(we assume that the government would use large proportion for infra
spending) projects would kick start capex cycle and push economic
growth higher in the medium term. The move is also likely to have a
habit changing impact in the Indian populous and there could be
increased belief of keeping cash in the banks rather than stashed at
home and use formal banking channels for their spending needs.
With a large part of the cash moving through the banking channels,
the banking sector is likely to be flush with funds in the near term
and this would help them reduce cost of funds for such period. Also
with more money being kept in the banking channel, some of these
low cost deposits may be sticky and improve the medium to long
term Current Account and Savings Account (CASA) ratio of the
banks. Another element of the demonetization would be reduction in
cash transactions in real estate. This is likely to reduce to real estate
prices and make it affordable to some extent. This may be visible
more in the rural belt, where many non-farming entities purchase
fertile farmland, not for farming but for money parking purpose.
The demonetisation and consequent reduction in shadow economy
would bring the demand for such farm lands down. This move is
likely to lead to better tax compliance, raise the Tax to GDP ratio and
improved tax collection. This could lead to lower borrowing and
better fiscal management. Also with lower cash transactions in the
near term, inflation may see downtrend in the near term. Also with
higher tax to GDP ratio, the government may also get enough
headroom to reduce the income tax rates, which can lead to higher
disposable income with people and can improve consumption
demand in the medium to long term.
Equities
Debt
Various Asset classes
(Gold, Bonds, Real Estate)
Overall Economic Impact
(Immediate and over the time)
EQUITIES
The day after the demonetisation move was announced and Trump
won the USpresidency, the BSE Sensex opened with a massive loss
of 1,300 points, butrecovered later. It rallied on 10 November and
reported net gains for these twodays of trading, only to tank 700
points the next day. Should you be worried?The global unfolding of
these two events and the market jitters created by thempresents a
value buying opportunity, says Dhananjay Sinha, Head,
InstitutionalResearch, Emkay Global. However, the impact of these
events is not over andinvestors shouldnt ignore them. The ripple
effects of demonetisation cannot beunderstated. There are major
industries in India that thrive on a paralleleconomy funded by black
money, says Ritesh Jain, CIO, Tata Mutual Fund.Though the
government is exchanging old notes with the new ones, it will
stillsqueeze the currency circulation in the shortterm. There may be
a negativeimpact on the GDP in the Oct Dec quarter, as
consumption shock getstransmitted into the system. Some rupee
appreciation in the forex markets isalso expected as notes in
circulation will decrease, says Anis Chakravarty,Lead Economist,
Deloitte India. If the RBI and the government dont step in toease the
liquidity situation, our exportoriented sectors may suffer.
Lets take a closer look at specific sectors, starting with real estate. It
is best toavoid realty stocks as the sector will be among the worst
affected by thedemonetisation move. The housing finance sector,
consequentially, will also beunder pressure. Housing finance
companies are likely to witness some stresson loans given to real
estate developers who are likely to face a liquidity crunchin the short
term.
Since most of the cash in circulation now will be converted to bank
deposits,banks will be the biggest beneficiaries of the
demonetisation move. We expectbanks to benefit because of more
deposits, especially lowcost deposits, saysRao. Though all banks
will benefit from this, investors should focus on bankssuch as HDFC,
ICICI that are strong on technology and can leverage theongoing
changes to their advantage.
DEBT
With the rupee remaining relatively stable, the debt market has
reactedpositively to both Trumps victory and the demonetisation
move.Bond prices may remain elevated as the flight to safety would
continue, saysSharma. This is because of the deflationary impact of
demonetisation. We arelikely to see some decline in inflationary
pressures as demand comes down inthe short term, says Anis
Chakravarty, Lead Economist, Deloitte India. Thiswill also keep
prices in check as the ability to hoard commodities and otherassets
will be greatly reduced, says Murthy Nagarajan, Head, Fixed
Income,Quantum Mutual Fund. Improvement in government finances
due to shift of theblack economy to whiteincreased tax compliance
and better revenues forgovernment is another positive aspect. The
debt market has also startedexpecting further rate cuts, which,
again, is good news for debt investors. Withthe household inflation
expectations coming down, the possibility of rate cuts isincreasing,
says Chakravarty. Experts expect a 5075 basis points rate cut inthe
next 69 months.
Severe liquidity issues in cash based sectors like Real Estate and
Jewellery
Other Impacts
Effect on parallel economy The removal of these 500 and 1000
notes and replacement of the same with new 500 and 2000 Rupee
Notes is expected to - remove black money from the economy as
they will be blocked since the owners will not be in a position to
deposit the same in the banks, - Temporarily stall the circulation of
large volume of counterfeit currency and - curb the funding for
anti-social elements like smuggling, terrorism, espionage, etc.
Effect on Money Supply With the older 500 and 1000 Rupees
notes being scrapped, until the new 500 and 2000 Rupees notes
get widely circulated in the market, money supply is expected to
reduce in the short run. To the extent that black money (which is
not counterfeit) does not re-enter the system, reserve money and
hence money supply will decrease permanently. However
gradually as the new notes get circulated in the market and the
mismatch gets corrected, money supply will pick up.
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