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Demonetisation —A Curse or A Bliss

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Indian Prime Minister Narendra Modi has announced a surgical strike against black money and corruption. In this bold move, he declared that the 500 and 1000 Rupee notes will no longer be legal tender from midnight, 8th November 2016. This measure has been taken by the PM in an attempt to address the resolve against corruption, black money, terrorism and counterfeit notes as mentioned above. This move is expected to cleanse the formal economic system and discard black money at the same time. One of the reasons that prompted the Government to demonetize Rs. 500 and Rs. 1000 notes is that their circulation was not in line with the Economic Growth. As per the Finance Ministry, during 2011-2016 periods, the circulation of all notes grew 40% but the circulation of Rs. 500 and Rs. 1000 notes went up by 76% and 109% respectively. Relatively speaking, the economy has grown only by 30% which is way below the money circulation.

India is positioned at position three in Cash-GDP ratio at 12% (highly cash intensive economy) ruled by Brazil at position one and South Korea at position two.

Cash circulation in the economy is around 85% of the total economy and cash share of total consumption spending is 68% in India

At an aggregate level, this move will significantly eliminate the existing stock of black money, fake currency and will benefit the economy in the medium- to long-run, but, the question as to how the creation of black money in the future will be prevented still remains unanswered.

Retailers could be at a major hit as surveys says that fall in cash sales in much bigger than increase in card sales.

We at the same time have good opportunity of:

  • Higher ratio of tax to GDP
  • Movement towards cashless economy
  • Though we are expecting as proposed tax slabs for both individual and corporate
  • Higher fiscal space
  • Increase in digital payments (as observed during first 30 days)
  • Boost in bank deposits

The jewellery industry in this phase

The jewellery industry has welcomed the government’s decision to ban old Rs 500 and Rs 1,000 notes, saying gold demand will rise as people will have more faith in the precious metal than the currency notes.

Exports (mainly CPD): Not major impact

After a subdued demand scenario for exports of Cut and Polished Diamonds (CPD) from India during

large part of FY15 and FY16 which had also resulted in pressure on profitability margins in the industry, some signs of revival in demand have been witnessed during H1FY17 as seen from Y-o-Y growth of 10.71% in exports of CPD in value terms; though export in carat volume remained largely stable. The growth is mainly led by increase in demand from the US which is the world’s largest diamond jewellery market. However, sustained pick-up in demand from China/Hong Kong (the world’s second largest diamond jewellery market) is still awaited.

The demonetization of high value Indian currency may not impact the CPD industry in a big way

especially as the major market for polished diamonds lies outside India. Also, larger organized sector

players in the industry undertake most of their purchase and sales transactions in US Dollars; with

mainly employee expenses required to be paid in Indian Rupee. However, it is expected that small and mid-size diamond polishing firms having main presence in the local trade could be impacted as lot of such trades are targeted towards smaller unorganized jewellery players who would be starved of cash following this step of the government.

Domestic market (mainly gold jewellery): medium term negative impact

It is estimated that the unorganized segment comprises around 70 – 75% of the domestic gold jewellery market; although the share of organized jewellery retail segment (comprising national and regional retail chains) is estimated to be growing at approximately 15% on y-o-y basis. During H1CY2016, jewellery demand in India was lower at 186.3 tonnes due to national jewellers strike impacting demand coupled with higher gold prices. Investment demand was also lower at 61.2 tonnes in H1CY2016. But, H2CY2016 was earlier expected to be better due to wedding season, good monsoon and seventh pay commission implementation. However, the demonetization program is likely to adversely impact consumer spending on discretionary/ luxury items and domestic demand for gems and jewellery is expected to be muted in the near to medium term. Although declaration of PAN had become mandatory for purchases above Rs. 2 lacs, still lot of small ticket gold/jewellery purchase in India was being undertaken on cash-basis (especially in the backdrop of the fact that more than 60% of the demand is estimated to originate from rural India). Though there was a brief spike in demand witnessed soon after the news of implementation of demonetization, in the medium-term a slowdown in demand for jewellery is expected with the smaller jewellery retailers in the unorganized sector being the most impacted. However, in the long-run, the move could turn out to be positive for organized jewellery retailers as they would benefit from a more level-playing field.

The impact of this move is felt across the various sectors with differing intensities and across varied time zones. 

Effect on GDP: Downward Bias to GDP Growth

The sudden decline in money supply and simultaneous increase in bank deposits is going to adversely impact consumption demand in the economy in the short term. Coupled with the adverse impact on real estate and informal sectors may lead to lowering of GDP growth.

The GDP formation could be impacted by this measure, with a reduction in the consumption demand. However, with the recent rise in festivals, demand is expected to offset this fall in an overall impact. Moreover, this expected impact on GDP may not be significant as some of this demand will only be deferred and will re-enter the stream once the cash situation becomes normal.

Lower Money Supply has a Deflationary Effect:

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 be reduced in the short run. Reduction in money supply can also have a deflationary effect in the economy. However, whether the impact of the reduced money supply will lead to deflation or contraction in demand or a mix of both will vary from sector to sector depending on the nature of goods & services. To the extent that black money (which is not counterfeit) does not re-enter the system, reserve money, and eventually, 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 speed.

Impact on Bond Markets:

Surge in deposits will create more demand for government bonds and other high rated bonds in a situation of demand for credit, leading to lower bond yields especially in the shorter end of the curve. At the same time, a reduction in leakages in systemic liquidity will reduce the scope for open market operation purchases in the coming days. We believe that the RBI will continue to sterilize excess liquidity from the banking system to keep the short term rates aligned with the policy rate.

Credit Impact across Sectors:

Impact of this policy measure will flow to the economy mainly through the Real Estate sector, which has strong linkages with sectors such as cement and steel and which will turn credit negative in the short-run. A significant impact in the short-run will be on the daily/weekly wage employment in the informal sector. The construction sector has one of the highest employment multipliers. The key segments of the economy where cash transactions play a vital role are real estate, gold and the informal sectors, which may face near term contraction. With more money coming into the banking ambit, deposit growth is likely to improve and positively impact the savings rate. The medium- to long-term gains are likely to outweigh the short-term pains.

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 increases in demand. This should eventually lead to strengthening of such systems and the infrastructures required.

Bank Deposit Rates to Soften:

We can expect a large amount of cash in circulation to be brought within the purview of the formal banking system by way of deposits. This is positive for banks, as part of this cash gets deposited as current account and savings account deposits, reducing banks dependence on higher cost borrowing. Deposit deployment remains a challenge in the short to medium term due to the current tepid demand for credit, subsequently pushing deposit rates lower.

Payment Banks to Benefit: Payment banks and others entities which are part of the transaction ecosystem are likely to be long term beneficiaries, as  more and more cash finds its way into the formal banking channels. We believe the cumulative measures taken to reign in black money will improve banking habits, create financial and transactional history of the informal & cash dependent segments and could, over the long term, make them ‘bankable’.

Investment in Financial Products: Investors in the short term will now believe that Cash is not the safest asset and there is little point in hoarding it. This will shift them from physical asset to financial assets where returns are also higher

Impact on Consumption Sectors

Agreement Cost of Real Estate May Rise: We expect that the real estate demand from end users is unlikely to be impacted, since a majority of them are backed by funding from bank loans. Demand from investors for real estate however may come down since in some cases, investors prefer cash transactions. If the proportion of earlier transactions in the real estate sector, which were allegedly done through partial cash payment reduces, the registered prices for real estate will go up. We expect the supply of real estate in the secondary market, which is strongly rumoured to have a large cash component involved, to suffer in the short term, which may in turn improve demand for residential real estate in the primary market.

In the medium term, the prices in this sector could regain on many fronts as developers rebalance their prices (probably charging more on cheque payment).

 Slowdown in Discretionary Spending to Hurt Consumer Durable Sales: Sales of White Goods like TV, Refrigerator & Washing Machine could slump as much as 70% as a good portion of the market is driven by Cash. This may continue for next Six Months till the dust settles down and there is adequate circulation of the new currencies.

Prices are expected to fall only marginally, due to moderation in demand, as use of cards and cheques could compensate for some purchases.

 Demand for Gems and Jewellery to Decline: We can expect the demand for gems and jewellery to decline in the next two to three quarters. This would result in a weakening in the credit profile of industry players due to the high working capital cycles and high operating leverage. The unorganized segment will be hit particularly hard, given the large proportion of unaccounted inventory and high proportion of cash sales. Over the medium-term the organized industry players will benefit at the cost of the unorganized players. Gold imports through the unofficial channels are likely to reduce. There will be no significant impact on jewellery exporters because it is mostly an organized market and sales are against invoices.

 High End Retail Demand to fall: We expect the impact on high end fashion retail and luxury goods to be more pronounced as discretionary demand in this segment will be curtailed. In case of Quick Service Restaurants, although 60%-70% of the transactions are currently in cash, the impact is likely to be moderate due to the low ticket size of purchases and high likelihood of patrons adapting to plastic money. We expect a limited impact to be caused on the food and grocery retail sub-segment, given the non-discretionary nature of purchases in this segment, since the buying cycle for the current month would have been largely influenced.

 Effect on various economic entities

The key segments of the economy where cash transactions play a vital role are real estate / construction, gold and the informal sectors as such. The role of cash transactions in case of real estate and gold is mostly dubious, however in case of the informal sectors it is the lifeline. For example, small and marginal farmers in the fruits and vegetables category typically require off-loading of their produce in the local Mandi in cash and could see an immediate impact. A sudden demonetization will adversely impact this segment of the economy and it will witness immediate contraction, though this impact will diminish over time.

With cash transactions lowering in the short run, until the new notes are naturalized widely into circulation, certain sections of the society could face short term disruptions in facilitation of their transactions. These sections are:

  • Agriculture and related sectors
  • Small traders
  • SME
  • Services Sectors
  • Households
  • Professionals like doctors, carpenters, utility service providers, etc.
  • Retail outlets

The nature, frequency and amounts of the commercial transactions involved within these sections of the economy necessitate cash transactions on a more frequent basis. Thus, these segments are expected to have the most significant impact post this demonetization process and the introduction of new notes in circulation.

Our View

  • Since most of the Rural Economy is based on Cash, it’s going to impact the Rural Economy
  • Sectors with a sizeable magnitude of Cash transactions such as Real Estate, Construction, Jewellery, high-end retail, White Goods and travel & tourism are expected to adversely affect.
  • It will push the economy because of flow of more money into the banking system.
  • In the long term, the economy will benefit from the reduction of the black money, which will lead to higher tax collection, better business environment, less corruption & transparency. It will improve the situation of Fiscal Deficit of the Country and hence reduce the fiscal deficit.
  • Interest rates will decline further because of decrease on Inflation as banks are flushed with huge inflows.

Will demonetisation be a success or a failure?

The answer depends on the criteria that one sets to define success or failure. The self-evident criterion is that demonetisation will be a success if there is a significant move of economic activity from the black economy to white.
There are also a number of non-criteria that are floating around. One is the idea that demonetisation will be a success if a significant part of the currency with the public disappears. That is, the holders decide to absorb the complete destruction of its value, rather than deposit it in a bank.
Why anyone should choose to do so now is not clear, since there is an amnesty scheme available that eventually leaves the holder with what is effectively about 35% (after taking into account the four-year lock-in of 25%) of the value. Of course, this is a kind of forced amnesty because the money expires if not deposited.

There is also the idea that one of the prerequisites for demonetisation to be declared a success (or concluded) is a complete replacement of the cash that was in the economy earlier. This is also a thoroughly misguided idea. Far from complete replacement, I would say one of the central goals of demonetisation is to leave the country with less cash, and cash of smaller denominations, than it was using earlier. Of course, no one knows how much less cash than earlier can the economy get by with, so that will have to be figured out dynamically .

At some point, probably within 2-3 weeks, as the worst shortages cease, the government should reduce or stop feeding Rs 2,000 and Rs 500 notes into the system and then replenish only with Rs 100 notes. Bulk usage of cash for transactions is hugely more cumbersome and detectable if Rs 100 notes have to be used.
At this point, the success of demonetisation is visible in two phenomena. One is the large amount of bulk cash that has been detected around the country. Amusingly, this has led to widely believed rumours that there is some high-tech wizardry like an RFID chip or that `isotope doped’ paper from the Mission Impossible 4 movie in these new notes. The truth is more prosaic, but just as much of a problem for those who are trying to handle the new currency in bulk.

The best or the most lethal thing about demonetisation is that practically all the cash in the country will have to be cycled through a bank account by December 30.
With cooperative banks excluded from this activity, by that date, every single one of the 15 odd lakh crore value of large notes will have a trail in what is effectively a single web of interlinked computer systems.

You could be a wise guy who has rented a dormant account from an unscrupulous bank manager (which is certainly happening) but such activities are questionable and detectable in bulk. This tracing is what is starting now and will become much intensive in the months to come. It’ll be impossible to hide large amounts of cash when it has been through the system so recently.

The second huge impact will be from the forced shift of retail and trade activities to cashless transactions. This shift is a one way street, for the same reason. It leaves a data trail. Talk to any businessman who is being forced to go cashless. He has understood that once he has generated a data trail of a certain sales volume from November to January, he will never be able to shift back to cash like old times.

Anyone who is not a prisoner of the ‘demonetisation-is-failing’ echo chamber, and is interacting with real businesses, knows well that there will be, there already is, a massive shift from the black economy to white. This is a revolution and you have to be blind and deaf (or pretending to be so) to not see it around you. And we haven’t even discussed real estate, which is, in many ways, the real story.

Final verdict:

Cheaper gold rate:

As gold rates are correcting internationally, jewellery sales have begun to rebound in December after having experienced a steep fall in the immediate wake of the demonetization.

Ticket Size:

Since more than 50% of sales were in cash only, due to cash curb now the ticket size of the jewellery would reduce though the total transactions would increase due to gold becoming cheaper and affordable.

Harvest buying:

In the rural areas the major issue is the banking systems. Farmers and other cultivators sell their harvest and get cash. Due to demonetization farmers faced a major issue to deposit a huge amount of cash with them because of harvest sales as the banks are quite far from their farms and the risk involved in carrying the same. This concern has reduced the confidence of farmers in saving in cash. Such harvest sales cash can be invested into gold and this reason can be inducted to the farmers boosting their confidence on buying jewellery. They can stay invested into gold till the next season of seed sowing arrives.

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