An Economic Outlook at Demonetization

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An Economic Outlook at Demonetization


What is “DEMONETIZATION”?
In simple words, it is an act of removing a certain currency (in current scenario, ₹1000 and ₹500 notes) as a legal tender.

The next question that bites us is – ‘Why resort to Demonetization’ ?
There are few reasons behind such a drastic step:

  • To combat inflation: to control the prices of commodity in the, one needs to understand the concept of demand and supply. by blocking the medium for supply, i.e., currency one can have a greater control over the pricing of the commodity.
  • To turn the economy towards digitalization: the idea of Digital economy is not farfetched. the technological advancements in the world has made people turn towards a better method of payments, i.e., plastic currency (Debit Card, Credit Cards etc.) or E-Economy (internet Banking, E-wallets, etc.)
  • To control Corruption: Most of the time the act of corruption occurs in terms of cash which is very hard to trace. Thus abolishing such a currency which is hidden deep under the cover, makes it merely a piece of paper.
  • To overcome fake currency in flow: As the notes in flow become old, i.e., when same currency is used for a long time, they can very easily be forged. Thus bringing new currency in the economy help curb this problem with a high efficiency.
  • To control Terrorism/Naxalism: to run an Organization, one needs a large funding, the bigger motive they hold, the larger is the economic requirement. therefore, demonetization holds such organization through their neck, and with no supply of money to fund their compatriots, such organisation melt down to shreds.

Now, the Demonetization in India has affected each and every person that is connected to Indian Economy. The Demonetization removed 86% of the cash that was used in our economy.
A country where almost 86% of transactions are in cash – was this a BOLD step or a VACUOUS act?

 

Impact on Bank Deposits:


The growth in Bank deposits, which was at a 53 year low at the end of March 2016, has seen a spike ever since the demonetization was announced in India. The total deposits collected by banks amounted to 
Rs 6 trillion (~USD 92bn) by 23rd of November 2016. With this rate of money deposited, entire INR 15 trillion (~USD230 bn) of currency demonetized is expected to be deposited by end of December 2016. If most of these deposits being made in the banks are emergency savings of households, most of these deposits will be withdrawn after government uplifts the withdrawal limit.
Given the huge surge in liquidity post demonetization, major banks in India like the ICICI ,HDFC and SBI have lowered their interest rates. For fixed deposit between 390 days to 2 years, ICICI bank has lowered interest rate to 7.10% from 7.25% while HDFC has made a reduction of interest rates up to deposits of 1 year to 6.75% from 7% and to 6.5% from 6.75% on maturities ranging from one year to years. Similarly, SBI has also announced reduction of interest rates on deposits for select tenors. With the reduction in fixed deposit rates, a reduction in lending rate was on the cards.

Impact on Real Estate:
Since Real Estate is driven by the black economy, this was the sector that was probably the worst hit of all the sectors. The Nifty Realty index gapped down after the day of the demonetization move and corrected -25% ( as indicated in the chart below, the NIFTYREALTY bounced of the Auto-SR very strong support of 152.5 on a weekly chart) before recovering a bit. It is still down almost -16% from 8th Nov.
Since many real estate properties have a big black money component, they are expected to go through at least a 20-30% correction, and hence for the foreseeable 2 quarters at least, chances are that this sector will probably go lower before it starts to improve.

Impact on Consumer Durables:
This sector is primarily driven by cash and hence has also been hit hard. It is down by almost 11.7% since the demonetization announcement.

Impact on Infrastructure:
The infrastructure sector is driven by massive investments from government as well as loans from banks. One of the healthy effects of demonetization is to increase the liquidity in the banking system as well as increase the funds that the government has for spending on items like infrastructure, welfare etc, so the Infrastructure is an obvious beneficiary of that. The fact that the NIFTYINFRA index has not been affected much (as is confirmed by the fact that it is up marginally since Nov 8th)

Impact on Information Technology:
The IT sector has been largely unaffected by the demonetization as it is export oriented and hence relatively better positioned to handle shocks in the Indian economy. Moreover it is probably also largely a cashless sector and hence also not affected due to the cash being taken out of the economy. The NIFTYIT chart below shows that the IT sector is actually doing better than from what it was on Nov 8th.

In conclusion, we can probably summarize the effect of demonetization on the overall economy as follows:

  1. In the short term, GDP will be down for at least a 1-2 quarters before recovering.
  2. A lot of black money will be converted to white and be deposited into the banks which will in turn help in the NPA problem that banks are facing.
  3. In the longer term, reducing of black money economy in the future should bring more people in the tax net and hence lower taxes as well as interest rates which will bode well for the overall economy.

Although this was what is called a “surgical strike” on black money and will have immediate impact on the existing black money, most economists agree though, that this move is not sufficient and several other reforms like tax reforms, real estate reforms etc need to be undertaken to curb the black money generation in the future.

 

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