<b>Akash Prakash:</b> Demonetisation: Impact on investors

It is a very positive move as, in the longer term, it will formalise the economy further and change deep-rooted behaviour

There is great uncertainty in the minds of investors as to what to do. Many respected economic commentators have heavily criticised this move. No other country in recent history has ever attempted to demonetise 86 per cent of its currency ($215 billion) with cash (14per cent of gross domestic product, or GDP) in the economy being two to three times the global norm and critical for daily functioning. How do you predict the impact of an event with no precedent, but with such sharp economic effects both long-term and today?

What is clear is as follows:

1. Banks will benefit, as much of this Rs 15 lakh crore in currency will get deposited. Even if only 10 per cent remains with the banks it means an incremental Rs 1.5 lakh crore of current and savings account ratio (CASA). Interest rates are headed lower system-wide as banks’ cost of funds decline, they lower rates and park these flows into government paper. Already we have seen Indian 10-year yields fall by 40 basis points in the last week, despite yields rising globally. Also remember this money left with the banks will have a multiplier compared to it sitting in cash. The system should be awash in liquidity. 

 

2. The Reserve Bank of India (RBI) will cut rates sharply and quickly. This reduction in currency will be a deflationary shock, with certain asset markets declining sharply and economic activity weak for the next two quarters at least. Inflation will decline giving the RBI the space to cut.

3. Financialisation of savings will accelerate as both property and gold will now be challenged as alternate stores of value. The cost of capital will reset downwards for the country.

4. There will be a significant negative wealth effect. Some percentage of this Rs 15 lakh crore will get wiped out. Black money that is either simply burned, or loses 30-40 per cent as the cost of conversion to legitimate money. Wealth destruction is also inevitable in property, as prices fall and markets freeze. There will be a shock to high end-discretionary consumption.

5. There is likely to be some behavioural change as those parts of the economy relying on cash need to adjust. Individuals and business that were using large chunks of cash on a daily basis will take months to rebuild these cash levels given the limits on daily withdrawals. In the interim, they will have to adopt e-payments or cheques to stay in business. As their business moves into the formal economy, it will be difficult to reverse and the tax buoyancy of economic growth will improve for the government.

6. For the vast majority of Indians, those having less than Rs 2.5 lakh in cash or agriculturalists, things will normalise in a few weeks. They will simply need to wait till they can get the new notes. For these people, it is largely a logistical issue of note replacement.

7. Small and medium-sized enterprises (SMEs) will be in trouble. Many are doing business entirely in cash. Demonetisation, combined with goods and services tax (GST), will kill their business model, which was dependent on tax and labour arbitrage. Many sectors will see large market share gain for the organised players. Lenders to the unorganised sector will need to stress test their exposures; there may be far greater credit issues here than investors are modelling.

8. Expect more measures to tackle the flow (fresh creation) of black money. Demonetisation handles the stock problem. Once the short-term logistics around cash replacement are fixed, expect new restrictions on use of cash and continued curbs on cash withdrawals. These steps will continue to force behavioural change.

9. I am frankly quite amazed as to the extent of cash in the system and its all pervasiveness. It seems that there is no supply chain untouched, and even large organised players need to deal with cash. There are many segments of the economy which operate only on cash. Whether demonetisation works or not, we have to attack this cash and the mindset. That much is certain.

Illustration by Ajay Mohanty

The big unknown is as follows:

1. Assuming that 20 per cent of the currency in circulation is black money and never gets converted, how will the government recycle this Rs 3 lakh crore back into the system? This burned cash was not all stuffed into mattresses. It was rotating in the economy and being used for transactions. It must be injected back into the economy and only the government can do so. It is not clear that RBI can simply hand over this money to the government as a windfall gain. Be that as it may but we also cannot suddenly contract the money in circulation by two per cent of GDP. A way has to be found to transfer this burned money to the government for it to inject back into the economy. The government should ideally transfer these gains to the poor using the direct benefit transfer (DBT) pipe. This will ensure the economy stabilises and the economic disruption of cash withdrawal is minimised. If the government tries to use the windfall for infrastructure or banks recapitalisation it will be too blunt a method to stabilise the economy and re-inject the cash.

2. Will the economy come back to normal within the next two-three months? Likely, but it will not be uniform. We are going to see share shifts between the organised and informal sectors. Between those who can adapt to a new more transparent world and those who cannot. Corporate performance will diverge sharply.

A big gamble, it will be, to my mind, very positive in the longer term in increasing the formalisation of the economy and changing deep-rooted behaviour. It will cause at least one quarter of significant economic and corporate pain. I would think the government deserves credit for taking the political and economic risk for a potential structural transformation. This is not going to be easy, but if it works, it is definitely worth the pain.

Investors may see markets sell off more both due to this event and a general wobble in emerging markets as bond yields rise and the US dollar continues to strengthen. I would use the ongoing correction to buy slowly and carefully with the clear understanding that the coming quarter is going to be very tough. The long-term story has improved to my mind. This could be transformational.

The writer is at Amansa Capital. These views are his own


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