To Embed This Infographic On Your Website (copy code below) <div style="clear:both"><a href="http://www.investorwhiz.com"><img src="http://bit.ly/2gcYBTg" border="0" /></a></div><div>Courtesy of:<a href="http://www.investorwhiz.com">Investorwhiz</a></div>
Demonetisation Impact On Indian Economy
On the fateful night of 8th Nov 2016, the Indian government announced that the 500 and 1000 rupee note will cease to be a legal tender with immediate effect. This announcement caught everyone by surprise and impacted over 86% of the currency in circulation. Never in the history of India was a demonetisation exercise carried out at such a massive scale. The move was made as a strike on the menace of terrorist financing, black money and counterfeit currency.
A Look at the Past: The Jan 1978 Episode
This was not the first time that demonetisation was announced in India. India had carried out demonetisation exercise twice before – in 1946 and in 1978. The 2016 demonetisation however, is unprecedented both in its massive scale as well as its repercussions. It needs to be kept in mind that India has amongst the highest levels of currencies in circulation at 13% of GDP. The same for other emerging markets is a meagre 4%
Back in 1978, currency worth INR 1.46 Bn, representing just 1.7% of total notes in circulation was demonetised. Of this only 68% was tended back. Despite a much lower amount of demonetisation, the impact on various economic parameters was material.
- There was a sharp rise in the deposit growth of banks
- The currency in circulation was sharply moderated
- Banks , being flush with liquidity, parked funds in G-secs thereby reducing the yields
- The credit growth was initially subdued by picked up within 4 months.
- There was no impact on GDP growth rate as the notes that were cancelled formed only 0.1% of GDP
The Great Demonetisation of 2016: Much Bigger, Much Bolder
The demonetisation initiative in 2016 is much bigger with far-reaching effects on the economy. It is a substantially more widespread exercise covering 86% of the total money in circulation and impacting 11% of India’s GDP
Before we look into the economic impact of this massive exercise, let us study the impact on RBI’s balance sheet.
Impact on RBI's Balance Sheet
As shown in the table below, total notes in circulation as on 11 Nov 2016 is INR 17.6 trillion. Over 86% of the currency is in 500 and 1000 denomination i.e INR 15 trillion. It is estimated that close to 20% is in black money. Therefore, we can safely assume that atleast INR 3 trillion of currency will not be tendered back. Remember that the figure back in 1978 was 68%.
Thus amount flowing back in the banking system will be around 80% of INR 15 trillion ie INR 12 trilion. We assume that 70% will be withdrawn within a month and so bank deposits will increase by INR 3.6 trillion. Thus, over INR 3.6 trillion of currency which is a liability in the books of RBI will vanish!
As shown in the table above, RBI had total liabilities of INR 32 trillion before demonetisation and will have only INR 29.7 trillion after demonetisation. So, in order to balance its accounting equation RBI will be forced to reduce its assets by INR 3.6 trillion.
What are RBI’s Options
RBI has the following three options to reduce its liabilities:
Special Dividend: RBI can declare a special dividend of INR 3.6 trillion which the govt deposits with RBI. In this case the deposits of RBI increase thereby matching the liabilities with Assets. If this scenario plays out, we can expect sharp rebound in economic activity induced by massive fiscal stimulus undertaken by the government. This option though much desirable is less likely to happen. There is no precedent of any central bank declaring a special dividend to the Government.
Cancel old debt of Government on its balance sheet: RBI can cancel Government’s old debt that will reduce its assets. It can alternatively, create a contingency reserve thereby increasing its liability to asset levels. Both these options will not lead to any change in the subdued GDP growth in the near term. Cancellation of old Government debt may lead to fiscal stimulus due to increased government spending by borrowing additional amounts.
Creates a special ARC: RBI may also create an Asset reconstruction company and buy out the NPAs of the PSU banks. The Indian banking sector is plagued with NPAs of over INR 1.6 trillion. Please read Indian Corporate Debt: The Ticking Time Bomb for details. This move will be a shot in the arm of the beleaguered Indian PSU banks and will lead to higher credit growth and renewed confidence in the economy.
Now that we have looked at how demonetisation will impact RBI’s balance sheet lets look at the short term impact on the Indian economy
Short term Impact on Indian Economy
The cost of this unprecedented move will be quite substantial in the short term. Most of these negative impacts will be short lived
GDP growth: The GDP growth will be negative in the next two quarters. There will be a pronounced declined in demand and hence a slowdown in the economic activity. Gold and real estate will be especially hit along with consumer discretionary.
Inflation: The demand slowdown will cause a downward pressure on prices and inflation will reduce. This may spur a rate cut by RBI
Liquidity and rates: The banking system will be flush with liquidity. This will lead to an increased investments in Gsecs, thereby reducing yields. The banks will lower their MCLR and this will lead to a bond rally. Lower rates will spur credit offtake by the end of second quarter.
Current Account Deficit (CAD): Non oil imports will take a hit due to slowdown in discretionary spending. This will lead to a narrowing of the CAD
Fiscal Deficit: It largely depends on what action RBI takes. Assuming RBI chooses not to declare a special dividend, Fiscal deficit will show gains due to higher direct tax collection only in FY 18. In the near term, due to subdued economic activity, indirect tax collections will be reduced thereby widening the fiscal deficit.
The demonetisation exercise of 2016, because of its sheer scale and far reaching effects, is historic in nature. It’s a true black swan event that has caught everyone by surprise. Though the long-term benefits cannot be denied, there is a lot of uncertainty in the minds of investors currently In our next article. We have published a detailed article on impact of demonetisation on various sectors. Do check it out.