The Demonetization Effect

The Demonetization Effect

Submitted To: Submitted By: Yogesh Yadav MBA Sem. 3

Subject: Management of Financial Services

B.K. School of Business Management 120 Feet Ring Road, Gujarat University, Navrangpura, Ahmedabad, Gujarat 380009

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Event Update The move by the government to demonetize Rs.500 and Rs.1000 notes by replacing them with new Rs.500 and Rs.2000 notes has taken the country with surprise. The move by the government is to tackle the menace of black money, corruption, terror funding and fake currency. From a market perspective, we think that this is a very welcome move by the government and which has taken the black money hoarders with surprise. The total value of old Rs.500 and Rs.1000 notes in the circulation is to the tune of Rs.14.2 trillion, which is about 85% of the total value of currency in circulation. This means that the total cash has to now pass though the formal banking channels to get legitimacy. 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.

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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 Page | 3

disposable income with people and can improve consumption demand in the medium to long term.

However there could be near term challenges In the immediate term, the reduced ability of the unorganized sector to deal in cash would impact the demand. Consumption items which had large element of cash dealing involved may see lower demand. Real estate and allied sectors may see near term to medium term negative impact. This HDFC Bank Investment Advisory Group may also lead to corporate earnings getting impacted in Q3FY17, as a large part of the old currency gets extinguished and takes time for fresh money to come into circulation. We will see some of the impacts of demonetization on the following:  Equities  Debt  Various Asset classes (Gold, Bonds, Real Estate)  Overall Economic Impact (Immediate and over the time)

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EQUITIES The day after the demonetisation move was announced and Trump won the US presidency, the BSE Sensex opened with a massive loss of 1,300 points, but recovered later. It rallied on 10 November and reported net gains for these two days 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 them presents a value buying opportunity,” says Dhananjay Sinha, Head, Institutional Research, Emkay Global. However, the impact of these events is not over and investors shouldn’t ignore them. “The ripple effects of demonetisation cannot be understated. There are major industries in India that thrive on a parallel economy funded by black money,” says Ritesh Jain, CIO, Tata Mutual Fund. Though the government is exchanging old notes with the new ones, it will still squeeze the currency circulation in the short term. “There may be a negative impact on the GDP in the Oct– Dec quarter, as consumption shock gets transmitted into the system. Some rupee appreciation in the forex markets is also expected as notes in circulation will decrease,” says Anis Chakravarty, Lead Economist, Deloitte India. If the RBI and the government don’t step in to ease the liquidity situation, our export oriented sectors may suffer. Let’s take a closer look at specific sectors, starting with real estate. It is best to avoid realty stocks as the sector will be among the worst affected by the demonetisation move. The housing finance sector, consequentially, will also be under pressure. “Housing finance companies are likely to witness some stress on loans given to real Page | 5

estate developers who are likely to face a liquidity crunch in 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 expect banks to benefit because of more deposits, especially low cost deposits,” says Rao. Though all banks will benefit from this, investors should focus on banks such as HDFC, ICICI that are strong on technology and can leverage the ongoing changes to their advantage.

DEBT With the rupee remaining relatively stable, the debt market has reacted positively to both Trump’s victory and the demonetisation move. “Bond prices may remain elevated as the flight to safety would continue,” says Sharma. This is because of the deflationary impact of demonetisation. “We are likely to see some decline in inflationary pressures as demand comes down in the short term,” says Anis Chakravarty, Lead Economist, Deloitte India. “This will also keep prices in check as the ability to hoard commodities and other assets will be greatly reduced,” says Murthy Nagarajan, Head, Fixed Income, Quantum Mutual Fund. Improvement in government finances due to shift of the black economy to white—increased tax compliance and better revenues for government— is another positive aspect. The debt market has also started expecting further rate cuts, which, again, is good news for debt investors. “With the household inflation expectations coming down, the possibility of rate cuts is increasing,” says Chakravarty. Experts expect a 5075 basis points rate cut in the next 69 months.

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Various Asset Class a. Bond prices will rise as interest rates drop. b. Real Estate is expected to fall by around 20 -25 % and stabilize thereafter. c. Effect on Gold is a bit uncertain, and may be neutral/ negative. Lower black money will depress demand, but at the same time Gold is a hedge against uncertainty and those still wanting to park black money may prefer to put it into Gold instead of cash.

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d. Equity is expected to benefit the most due to three reasons. One, there will be a gradual shift from physical assets (real estate/ Gold) to financial assets. Two, the organised sector (corporates, especially listed ones) will benefit due to less cash transactions. Lastly, lower inflation and interest rates will benefit listed corporates through lower borrowing costs, thereby increasing their profitability and valuations. Thus Asset Allocation and re balancing thereof will now play an even more important role, making proper financial planning imperative.

Overall Economic Impact a. GDP growth is expected to be negative for around 6 months. However subsequent 2 years will see sharp “hockey stick” revival in growth. Page | 8

b. Inflation is expected to fall sharply with fall in Real Estate prices and transaction costs thereof. c. Government Deficit will see a huge windfall in the next 2 years. d. Currency is expected to strengthen as inflation drops and economy gets a boost. e. Banking System will get a boost, as around Rs 7-8 lakh crores base money (new legal money) will enter the system, which will further create around 3-4 times more money due to re-circulation. f. Real Estate and Jewellery sectors, though battered initially will stabilize in the next 6 months.

Immediate impact: is expected to be negative all round:  In the short term it will be a logistical nightmare to manage the cash replacement in banks and smooth functioning of the banking system  Slowdown in consumer spending due to limited cash availability  Severe liquidity issues in cash based sectors like Real Estate and Jewellery  GDP will decline in the next 2 quarters due to reduction in overall spending

Other Impacts Page | 9

 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.  Effect on various economic entities with cash transaction lowering in the short run, until the new notes are spread widely into circulation, certain sections of the society could face short term disruptions in facilitation of their transactions. These sections are:  Agriculture and related sector  Small traders  SME  Services Sector  Households  Political Parties  Professionals like doctor, carpenter, utility service providers, etc.  Retail outlets  Effect on Online Transactions and alternative modes of payment: With cash transactions facing a reduction, alternative forms of payment will see a surge in demand. Digital transaction systems, E wallets and apps, online transactions using E banking, usage of Plastic money (Debit and Credit Cards), etc. will definitely see substantial increase in demand. This should eventually lead to strengthening of such systems and the infrastructure required.

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Views From an equity market perspective, this move would be positive for sectors like Banking and Infrastructure in the medium to long term. This could be negative for sectors like Consumer Durables, Luxury items, Gems and Jewellery, Real Estate and allied sectors, in the near to medium term. This move can lead to improved tax compliance, better fiscal balance, lower inflation, lower corruption, complete elimination of fake currency and another stepping stone for sustained economic growth in the longer term.  In spite of the initial hiccups and disruptions in the system, eventually this change will be well assimilated and will prove positive for the economy in the long run.  Black money hoarders will definitely lose out, eventually boosting the formal economy in the long run.  Short term fall in real estate prices might benefit middle class citizens.

 This move by the Government along with the implementation of the GST will eventually make the system more accountable and efficient.

Bibliography  Demonetization and its impact report by HDFC Bank Investment Advisory Group  http://economictimes.indiatimes.com/wealth/invest/howdemonetisation-move-and-donald-trumps-victory-impact-yourinvestments/articleshow/55384579.cms

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 http://www.careratings.com/upload/NewsFiles/SplAnalysis/Effects %20of%20Demonetization%20of%20500%20and %201000%20notes.pdf  http://www.blog.sanasecurities.com/demonetisation-impact-stockmarkets/  http://www.brameshtechanalysis.com/2016/11/challenges-andeffects-of-demonetization/

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