The sudden and abrupt announcement by the government to make the currency notes of INR500 and INR1,000 invalid as legal tender from mid night of 8 November is part of the government’s attempt to crack the whip on black money and fake currency, says India Ratings and Research (Ind-Ra). This comes after the disappointing collections made under the Income Disclosure Scheme (IDS), which gave the option to disclose unaccounted money. 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 how the creation of black money in the future will be prevented still remains unanswered.
The impact of this move will be felt across sectors with differing intensities and for a different period of time.
Cash Economy To Witness Contraction: The currency of the aforesaid denominations constitutes around 86% of the total value of the currency in circulation, thus its impact on the cash economy will be significant. The key segments of the economy where cash transactions play a vital role are real estate/construction, gold and the informal sectors. The role of cash transaction 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 vegetable category typically require off-loading of their produce in the local Mandi in cash and could see an immediate impact. A sudden demonetisation will adversely impact this segment of the economy and it will witness immediate contraction, though the impact will diminish over time.
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. This coupled with the adverse impact on real estate/construction and informal sectors may lead to lowering of GDP growth. However, Ind-Ra feels the impact will be felt more in Q3FY17 and the system is expected to readjust thereafter. Therefore, Ind-Ra retains its GDP growth forecast of 7.8% for FY17 with a downward bias and will monitor this aspect closely.
Lower M3 has Deflationary Effect: 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.
Impact on Bond Markets: Surge in deposits will create more demand for government bonds and other high rated bonds in a situation of tepid 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. Ind-Ra believes the RBI will continue to sterilise 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/construction sector, which has strong linkages with sectors such as cement and steel and they will turn credit negative in the short-run. A significant impact in the short-run will be on daily/weekly wage employment in the informal sector/construction sector. Construction sector has one of the highest employment multiplier. The key segments of the economy where cash transactions play a vital role are real estate/construction, 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 pain.
Impact on Financials
Bank Deposit Rates to Soften: Ind-Ra expects a large amount of cash in circulation to be brought within the purview of the formal banking system by way of deposits. This is structurally a positive for banks as part of this cash gets deposited as current account and savings account (CASA) 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, thus pushing deposit rates lower.
NBFC’s Asset Quality Faces Pressure: Ind-Ra believes asset quality of retail asset financers, especially NBFC’s which have developed expertise in the credit assessment of the informal segment and have built models around it to come under pressure in the short term. Within NBFC’s, asset quality of financers with a large dependence on cash collection remain vulnerable in the short term. In the longer term the implication could be a risk profile shift for the NBFCs, as the stronger borrower profile could potentially migrate to banks. Over the medium term, the demand for real estate especially in the secondary market and tier-ii cities where cash component as a proportion of transaction is significant could face a slowdown. The trickle- down effect could encompass the entire real estate sector putting pressure on demand itself. This could adversely impact NBFC’s/housing financers with a large proportion of exposure (LAP/Mortgage) built with a self-employed customer profile. We believe NBFC-MFI’s and Small Finance Banks (SFB’s) may not be significantly impacted in the long term considering the cash flows of the borrower segment are usually in the smaller denomination. However, there could be near term disruptions in the collection cycles along with a spike in over dues, which could put their liquidity strength and the disbursal cycle under pressure.
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. Ind-Ra believes the cumulative measures taken to rein in black money will improve banking habits, create financial and transactional history of the informal/cash dependent segment and could over the long term make them ‘bankable’.
Impact on Consumption Sectors
Registered Prices in Real Estate May Rise: Ind-Ra expects 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. Much of the investor demand is in relatively higher value transactions of above INR 10mn, which may now see lower demand. If the proportion of earlier transactions in the real estate sector, which were allegedly done through partial cash payment, reduces, the registered prices of real estate will go up. Ind-Ra expects 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.
Auto Secondary Sales May Fall: Sales of vehicles in the second hand market for original equipment manufacturers will get impacted, which will have a ripple effect on OEM sales, as buyers will not be able to dispose of their old vehicles easily.
Slowdown in Discretionary Spending to Hurt Consumer Durables: To have moderate to negative impact in the short term, since purchases of consumer durables in cash will be impacted by the slowdown in discretionary spending.
Demand for Gems and Jewellery to Decline: Ind-Ra expects the demand for gems and jewellery to decline in the next two to three quarters. This would result in weakening in the credit profile of industry players due to the high working capital cycles and high operating leverage. The unorganised segment will be hit particularly hard given the large proportion of unaccounted inventory and high proportion of cash sales. Over the medium-term the organised industry players will benefit at the cost of the unorganised players. Gold imports through the unofficial channel are likely to reduce. There will be no significant impact on jewellery exporters because it is mostly an organised market and sales are against invoices.
High End Retail Demand to Fall: Ind-Ra expects 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 on the food and grocery retail sub-segment, given the non-discretionary nature of purchases in this segment, as well as since the buying cycle for the current month would have been largely completed. Ind-Ra expects demand across the retail sub-segments to shift to the organised segment over the medium term.