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The move by
the legislature to demonetize Rs.500 and Rs.1000 notes by supplanting them with
new Rs.500 and Rs.2000 notes has taken the country with surprise. The move by
the government is to tackle the threat of black money, corruption, terror
funding and counterfeit currency. From a market perspective, this is an
exceptionally 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 around 85% of
the aggregate value of currency in circulation. This implies the total cash has
to now pass through the formal banking channels to get legitimacy. The World
Bank in July, 2010 evaluated the measure of the shadow economy for India at
20.7% of the Gross Domestic Product (GDP) in 1999 and climbing to 23.2% in 2007.
Expecting that this figure has not rose from that point onwards and that the
cash component of the shadow economy is also proportional (it could be higher),
the surveyed unaccounted value of the currency could be to the tune of Rs.3.3
trillion. Presently, post the announcement of demonetization by the government,
this cash would need to be either represented by paying the relevant taxes and
penalties or would get extinguished.

The
positive macro benefits of this move by the government

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This move by
the government is likely going to have long haul benefits for the economy. The removing
of the significant amount of black money would decrease from the liabilities of
the government and would add to its finances. This can have very strong
ramifications as the government would get money to spend without borrowing from
the market. This would infer that while financing costs will be low, the government
spending on large infrastructure projects would kick start capex cycle and push
economic growth higher in the medium term.

The move is also
inclined to have a propensity changing effect in the Indian population and
there could be increased belief of keeping cash in the banks rather than
reserved at home and utilize formal banking channels for their spending needs.
With a large proportion of the cash moving through the banking channels, the
banking sector is likely to be flushed with funds in the near term and this
would help them decrease 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
impact of the demonetization would be reduction in cash transactions in real
estate sector. This is probably going to reduce the land costs and make it
affordable to some extent. This might be more prominent in the rural areas,
where a number of non-farming entities buy farmland, not for cultivating but
rather for cash hoarding. The demonetization 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 increased
tax collection. This could lead to lower borrowing and better fiscal
management. Also with lower cash transactions in the near term, inflation may
see downwards trend 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.

However
there could be near term challenges

In the near term,
the reduced capacity of the unorganized sector to deal in real money will
impact the demand Consumption items which has a huge element of cash dealing
involved, may see lower demand. Real estate and allied sectors may see near
term to medium term negative impact. This may also lead to corporate earnings
getting impacted in Q3FY17, as a large part of the old currency gets extinguished
and takes time for new money to come into circulation.

Impact on GDP and economy

The Indian Economy which was labeled as the
“fastest growing major economy” in the world and the “only bright spot” among
Emerging Markets appears to have slowed down even before the recent “shock
therapy” of “demonetization”. The recently released growth figures from the
Central Statistical Office, shows a decline in the Indian economy even during
the quarter before demonetization happened.

India’s GDP which grew at 7.6% in FY 2015-16 is likely to come down by 0.5% to 1.5% as per
reports of various agencies. This is due to less availability of cash in cash-intensive sectors like manufacturing and
real estate. Even the automobile industry which was growing at a fast pace
earlier has seen a drop in the October-December quarter of 2016. Purchasing
power of consumers has been negatively affected due to cash not being readily
available.

Indian economy is largely cash driven with more than 90% transactions taking place in
cash and digital transactions accounting for just the remaining 10
percent.

Banks have also been concentrating only on the deposit and
withdrawals with the result that their core function of issuing loans has been adversely affected. Also
current account customers, who are largely business owners, need huge amounts
of cash at short notice and they have not been able to avail cash and credit
owing to restrictions on withdrawals and inability of banks to focus on the
task of issuing loans.

 

Also since consumer demand has dropped and consequently
industrial production has declined, employment
generation has been adversely impacted by the currency
demonetization drive. Since the manufacturing sector which accounts for the
highest employment of skilled and semi-skilled laborers, is witnessing slowdown
in production; not only less jobs are being created but lay-offs are also
taking place at a very high rate.

 

While
this move by the Indian Government will definitely remove the fake currency,
its impact on the black economy and corruption is highly debated. While in
isolation demonetization might not be effective in shrinking the black economy
in the long run, it will definitely bring in most of the money back into the
system from where tracing and tracking can be done with much ease. Further
moves by the government like not allowing high amount of cash expenses as a tax
deductible expense is expected to increase the tax revenue of the government.

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