Macro implications of our high value currency demonetization


What is Demonetization?

Demonetization is an act of stripping a currency unit of its status as legal tender. Demonetization is necessary whenever there is a change of national currency. The old unit of currency must be retired and replaced with a new currency unit. Currency demonetization is also an event when a country bans or replaces its own currency to new currency of any value to fight against corruption and black money.

We have experienced one of the most astonishing economic move by an Indian government in the post Independence era in the form of Currency Demonetization baring one before in 1978. This is going to impact entire 1.2 billion plus Indian population; Rich and Poor, Service class & Business Class, Politician to common men all are going to get impacted with this move. India is a cash economy. Cash is going to be out for a small period of time but it will affect our long term habits. Business is going to be easy with legal money but is going to be difficult with illegal money.

Good, very bold, big & risky political move:

In a historic move the PM announced demonetization of Rs 500 and Rs 1000 notes starting Nov 9th 2016, barring some exceptions. Before delving into the impact of this on business and markets, we must understand the overarching strong political message that this move carries. As a leader chosen in a democracy, this of course is a huge political risk that current government has taken. Weaving together the timing, the preparation and the recently concluded IDS (Income Declaration Scheme), this is clearly a very well thought through step, provided it is executed well too- this move would in fact go down in history as Modi's master stroke to cleanse the black economy and bringing informal system to formal one (GST will aid this process). At this point, let's also not discount that this move has left a strong powerful lobby very unhappy and has the potential to destabilize the internal security. Despite such scope of a backfire, going ahead with this move and squeezing the time window to react to a minimum shows the calculation that could have gone behind undertaking such a courageous, politically risky step.

Short term growth may be affected:

Given the shock type nature of this move, this is likely to adversely affect – both consumption and capex in the short term. This demand shock in effect creates fresh slack in the economy and facilitates the disinflation process. The freshly induced slack would call for sharper monetary easing to compensate for this negative impact, which is shaving off 50-100bps from growth. To ensure that the fall in growth is floored, both monetary and fiscal policies would have to work together. We could see more on this in the next Union Budget slated to be presented on 1st February, 2017.

The banking sector:

Moving on to the impact on banking sector, RBI balance sheet and public finances- RBI estimates that currently about 14 lakh crore worth of Rs 500/1000 notes are in circulation in the economy. As these cease to become legal tender, part of it should get back to the banking system, adding to the deposit base for banks. While banks get flushed with deposits (some may be temporary) the avenues to deploy this back into the system remain sparse. So, flushed with deposits and reeling under fewer opportunities to lend, banks may chase bonds. 

Big bump for fiscal:

It is understood that all of this INR 14 lakh crore doesn't flow back into the banking system, whatever doesn't, basically reduces RBI's unclaimed liability to the citizens (Remember a currency note is a promise by the RBI to pay). So, as RBI experiences this liability destruction, it may end up with super normal profits. Could this be transferred by the RBI to the govt? If done, it can provide big fiscal push for growth. There may also be a bump in tax collections as many enterprises rush to disclose more income to the system.

Easing of monetary policy ahead:

One must understand and appreciate that this move hasn't only opened up avenues for monetary expansion going forward but has resulted in monetary easing by taking systemic liquidity to surplus from deficit. This surplus liquidity could potentially lead to effective rates settling between Repo and Reverse repo (tantamount to monetary easing). This will create room for deeper monetary easing in the longer term with an expectation of further rate cut cycle of 25 – 75 bps in the next 3 to 6 months.

So clearly, this move bodes well for high duration strategies in your portfolios. The underlying fundamentals even prior to this move were supportive of more monetary easing, after this move the need to do the same and more has only become more urgent.

Some types of credit will be under pressure:

Post the announced change, it is foreseen that the credit quality may worsen in certain segments. LAP is certainly one of them. Valuations and ability to service debt of some real estate companies can get hit if property prices start re-pricing lower. Moving on to SMEs, their reduced degree of financial flexibility compounded by stressed loan collateral value could cause some to default. Also, lending entities which have a large proportion of borrowers paying in cash may face a lot of heat in the short term. NPAs could rise for some of these players.


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