THE BLOG

7 Reasons Why Demonetization Is A Masterstroke By Modi

10/11/2016 4:30 PM IST | Updated 11/11/2016 8:57 AM IST
NEW! HIGHLIGHT AND SHARE
Highlight text to share via Facebook and Twitter
Adnan Abidi / Reuters

I emphatically welcome the government's decision to demonetize ₹500 and ₹1000 currency notes in circulation in the economy as bold and revolutionary, and one that will have tectonic impact on the ubiquitous parallel economy in the country. The move will significantly strengthen the government's systematic efforts (including special investigation team on black money, amending DTAA with Mauritius and Cyprus, amending the Benami Transactions Act, and the more recent Income Declaration Scheme) over the last two years to curb black money in the economy.

In a single master stroke, the government has attempted to tackle all three malaises plaguing the economy—a parallel economy, counterfeit currency and terror financing.

With the latest move, it is reasonably clear that the economy stands to benefit on several fronts:

1. Boost deposit base and savings

Global agencies have pegged the size of the parallel economy in India at close to 23% as of 2007. Basis this, we estimate unaccounted cash in the economy to the tune of ₹4500 billion, of which a certain significant proportion will make its way to the banks, thus boosting deposit base as well as financial savings:

  • The banks' deposit base is expected to receive a fillip of 0.5-1.4% of GDP.
  • In turn, financing savings can be expected to rise by close to this proportion due to switch from savings from unproductive physical assets to financial assets.

2. Improve monetary transmission and reduce lending rates

  • A rise in deposit base will allow banks to lower the blended cost of funds as higher CASA (current accounts, savings accounts) deposits help to replace the high cost of borrowing and lower overall cost of funds. We expect banks to reduce deposit rates by ~125 bps over the next six months.
  • The new regime of MCLR (Marginal Cost of Funds based Lending Rate )will immediately take into account the lower cost and will thereby lead to a decline in lending rates, which will boost economic activity in the medium term.

3. Create room for further monetary accommodation

  • With improved monetary transmission, economic efficiency and structural moderation in currency in circulation, there is likely to be a greater room for the RBI to ease monetary policy rate further. I am hopeful that the RBI will ease by another 100 bps in 2017-18 to a repo rate of 4% by March 2018.
  • The piecemeal liquidity support from OMO purchases will now to a larger extent be addressed by the structural change in currency demand

4. Ready, steady, now go: financial inclusion via Jan Dhan

Over the last two years, while the number of Jan Dhan accounts has recorded a stellar growth, the share of these accounts in total deposit base of the banking system has remained under 1%. The demonetization drive of higher denominated notes should give a push to cash deposits in Jan Dhan accounts, of which close to 43% so far have remained dormant. In addition, the move will help to inculcate banking habits among the large unbanked population in the country.

5. Support government finances

  • With some part of unaccounted money making way into the formal channel, the government stands to benefit from higher income tax collections. This should help cushion the government's FY17 fiscal deficit target, especially post the shortfall in anticipated spectrum revenues.
  • The latest move will move the economy from the unorganized to organized sector, dovetailing into the GST architecture that is expected to come on board next year. This is likely to enhance the government's ability to tax commercial transactions resulting in a structural improvement in tax to GDP ratio in the economy.
The Indian economy has been provided a new lease of life—a "reset" if you will—with huge positive implications for liquidity, inflation, fiscal and external deficit in the short term.

6. Positive impacts from a bond market perspective

  • Improvement in bank deposit base leads to higher SLR (statutory liquidity ratio) demand.
  • On the supply side, with tax buoyancy seeing an improvement, supply of g-secs is likely to get more rationalized due to gradual reduction in fiscal deficit over time as the impact of FRBMA (Fiscal Responsibility and Budget Management Act) is underway.
  • Anticipation of monetary easing to further support bonds.

7. Rise in GDP growth potential

While there are short-term implications for growth in cash-intensive sectors such as real estate, construction, and discretionary household consumption in general, I believe that long-term benefits for GDP growth will outweigh the short term transitional impact. We are now surely heading towards a 9% GDP growth by FY2018-19.

Conclusion

In a single master stroke, the government has attempted to tackle all three malaises currently plaguing the economy—a parallel economy, counterfeit currency in circulation and terror financing.

In addition, the Indian economy has been provided a new lease of life—a "reset" if you will—with huge positive implications for liquidity, inflation, fiscal and external deficit in the short term. Over the next two-three years, improvement in India's position on transparency and corruption in the global stage will further add to its investor appeal. With GST on the anvil, India is now on the cusp of higher growth in the medium term—to be steered by the organized sectors including MSMEs and the revival of the private sector capex cycle.

Save money at grocery store?

More On This Topic