India’s demonetisation drive: short-term pain for long-term gain

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On the night of 8 November, as the world awaited the results of the US elections, India was split between shock and awe. In a bold and unprecedented move, the government removed the legal tender status of INR 500 and INR 1 000 notes, which together made up no less than 85% of the cash in circulation and whose worth totalled almost INR 15 trillion (USD 220 billion). By doing so, the government made a decisive move to tackle black economy cash transactions, corruption and counterfeit currency, which was concentrated in these high denomination notes. India’s demonitisation also created disruption in the short term, dragging the local equity market lower in the days following the move.

A short-term pain

Cash has long played a major role in the Indian economy. Before the government’s move, cash represented some 12.1% of India’s GDP. Around 90% of consumer purchases are made in cash. In some sectors like real estate, between 35% and 40% of sales are transacted in cash. As a consequence, demonetisation is creating a short-term disruption in consumption and GDP growth, which is expected to slow in the coming two quarters. On the positive side, weaker demand should also put pressure on prices, which should push inflation lower in the near term. Lower growth and inflation should reinforce the case for further rate cuts to stimulate economic activity.

Exhibit 1: INR 500 and INR 1 000 notes represented 85% of currency in circulation

demonetisation

Source: RBI, Credit Suisse estimates, November 2016

A positive for banks and monetary transmission

Meanwhile, banks are seeing a surge in liquidity, with an increase of some INR 3 trillion (USD 44 billion) in deposits over the first five days following demonetisation. While some deposits may transfer back to cash as the Reserve Bank of India (RBI) slowly reintroduces new notes to replace those taken out of legal circulation, we believe the move should lead to a durable increase of around INR 2-3 trillion in bank deposits. As such, monetary transmission should improve. Indeed, such a rise in the deposit base will allow banks to lower their overall cost of funds as higher current account and savings account (CASA) deposits help to offset the high cost of borrowing.

Towards greater financial inclusion

The demonetisation move should also help accelerate the pace of financial inclusion. In 2014, only 60% of India’s 250 million households had a bank account. Through its financial inclusion plan, the government has facilitated the opening of more than 200 million ‘Jan Dhan’ accounts over the last two years, although 43% of these are considered as dormant. The demonetisation drive should help to develop banking habits and to boost cash deposits in Jan Dhan accounts. The extent of the gains will also depend on the extent to which the government takes this opportunity to promote digital payments as a convenient alternative to cash.

Higher formal economy should help tax collection

According to World Bank estimates from 2007, the parallel economy in India was equivalent to 23.7% of India’s GDP. As more of the unaccounted money makes its way into the formal economy, the tax base should progressively increase, leading to likely gains for the government through higher tax revenues. The fiscal headroom should allow the government to maintain fiscal discipline and address supply-side bottlenecks, which in turn would also be supportive of its medium-term inflation target.

India’s demonetisation: monetary “creative destruction”

After the recent progresses made towards the implementation of the Goods and Services Tax (GST), this demonetisation move is further proof of the government’s reform drive. While this undoubtedly means some short-term pain for growth in cash-intensive sectors such as real estate, construction and discretionary household consumption in general, we believe this monetary “creative destruction” also bears the potential to propel India from its traditional cash-intensive economy into a more modern one with a reduced parallel sector. Over the medium term, this should generate benefits such as higher government resources and spending, better monetary transmission, greater financial inclusion and higher household financial savings, ultimately boosting India’s potential GDP growth.


The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, portfolio transaction, liquidation and custody services for funds invested in emerging markets may carry greater risk.

Paul Milon

Investment Specialist, Indian Equities

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