Demonetization and the Outlook

My take on Demonetization of Currency Notes announced on 8th of November in India :

Approx. US$250 Bln is official money circulation in economy by RBI. This appears as a liability in RBI’s books. 85% of the circulated amounts are in denominations of 500 and 1000 (US$ 212 Bln) .If we consider 40% of the transactions to be in informal economy, the amount comes to about US $85 Bln.

What happens next?

Those with legitimate income – No issues – they can deposit the money in the banks or exchange through banks. We shall see deposit in banks to the extent of 250 * 0.85 * 0.6 = US$125 Bln by March, 2017

Those with un-accounted cash / black money – Informal economy – 250*0.85*0.4 = US$ 85 Bln

a. It will either expire as the holder shall not deposit with banks due to fear of getting caught by revenue authorities

b. Declare the unaccounted cash, pay taxes on it (up to 60 – 80%)

Advantages for RBI, Government, Economy –

a. Out of the US$85m in the informal economy, say 50% comes through official channel (house hold deposits), still about US $40-45 Bln value of notes would expire after March 2017 resulting in either reducing the liability of the RBI or increasing tax collections by the government due to tax penalties on declared unaccounted cash.

b. Fiscal deficits would be largely set-off due to the above gains. This would allow the government to significantly increase their planned expenditures in future.

c. Another significant benefit would be discontinuance of existing fake notes.

Economic Outlook

Short term (next 6 months)

a. Hassles for individuals in depositing old notes and exchanging /withdrawing new notes through ATMs/Banks,

b. Real estate sector takes the biggest hit in the short term and illicit money would no longer be available to buy the assets, prices should drop and hence the buyers would watch the market and wait for the opportune time to buy properties.

c. As the illicit money would not find its place and with limitations in the money supply, the consumer spending would be lower in the short term and hence we shall witness a lower economic and GDP growth, lower inflation in the next 3-6 months.

Medium term (after 6 months)

a. The demand for real estate sector and properties might increase due to drop in property prices and lower interest rate for the individuals/corporates

b. The money circulation in the economy would increase due to increased banking, payment platforms, e-wallets which would increase the banking and online transactions ( money multiplier effect) and hence income for banks allowing them to reduce the interest rates

c. Due to higher consumptions/demands and lower interest rates, GDP and Inflation would increase.

d. INR against USD might appreciate due to inflation drop (though short term) interest rate drop, improved domestic sentiment, lower deficits etc

e. Gold Market – Gold demand and hence prices might increase in future as the hoarders would like to invest in gold which is considered as a better bet

f. Equity Markets – Equity Valuations should improve due to increase in present value of future cash flow impacted by lower interest or discounting rate.

g. Government would definitely demonetize and discontinue 2000 note in future. Currently it has been issued to handle liquidity and logistical challenges.