8th November was nothing short of a dramatic movie scene. A country of 1.3 billion woke to an announcement that rendered 85% of the currency in circulation worthless in T-4 hours. In a live televised speech, Narendra Modi forced people to burn the midnight oil and ignited heated discussions about demonetization of 86.4% of the currency in circulation by value (24.4% of a total 90.27 billion currency pieces by volume). Needless to say, while few rejoiced the PM’s move to tackle the black economy, the majority got time to re-test their accounting skills.
A rather bold move even for the more developed near-cashless economies has taken the land of east by storm. India is an economy where cash accounts for 98% of all transactions by volume and 68% by value. The trailing effects of this policy are forecasted to extend over the next two financial quarters raising the big question amidst India’s move to an all exclusive investment hub in the slowing world economy: Will this move be a policy disaster for the Indian Prime Minister?
Let me start by taking a look at the Public Sector Banks (PSBs) in the economy. PSBs, which account for 75% of country’s total lending activities, have a bad loan burden exceeding almost 4 trillion rupees. Theses bad loans have hampered credit growth in the economy which fell to 8.4% in April 2016 from the year-earlier 9.1% (according to official data). The burden of rectifying this problem falls upon the government, a majority stakeholder in all listed PSBs. Even though the Finance Minister, Arun Jaitley, announced a 700 billion rupees aid package to recapitalise the banks and implement the remaining agenda of the Indradhanush package of PSB governance reforms earlier this year, RBI reported that it would still fall short by 2.5 trillion rupees for reaching Basel III norms. The dire situation of the banks which required serious recapitalisation schemes to keep up with the Basel III agreement to prevent a future GFC-like situation has been partly taken care owing to the demonetization move..
The demonetization drive has seen deposits in excess of 1.1 trillion rupees (as of November 30th). It has single handedly solved a big chunk of the problem which the government faced. Demonetization has also positively affected the assets and liabilities of the RBI. Simply put, for every bill that the RBI prints, it has to buy government bonds. On the day of demonetization the outstanding value of the scrapped Rs. 500 and Rs. 1000 notes was 14 trillion rupees out of which 8 trillion were deposited in the banks. It is expected that another 3 trillion will be deposited by the deadline of 30th December which leaves an unaccounted 3 trillion in the market. This means that the liability side of the Reserve Bank would decrease by a significant amount. RBI will be able to lend this amount to the government to carry out infrastructure spending and fiscal measures without running excessive deficits.
The flip side to this massive capital inflow is interesting to observe as well. Since banks have to pay interest on savings without an opportunity lend out due to RBI’s requirement of maintaining a 100% CRR, this inflow of cash has added to their liabilities. Commercial banks have bought huge quantities of government bonds to balance out, pushing government yields down when yields all around the world are rising (after US presidential elections). RBI has been forced to cut the key lending rate, the RBI repo. Low yields and interest rates are harmful for the Indian economy at a moment when a weakened rupee and low rates are leading to capita flight towards the US.
While demonetization is aimed to curb the black economy (estimated to be as much as 20% of the Indian GDP), many argue it will do little since majority of the black holdings are in the form of real estate or gold. Although the principal argument given by the ministers supporting the move is that a move towards a organised and formal economy is bound to add to the GDP, reality can be different from theoretical economics. Major financial institutions and forecasters Fitch and HSBC are among the few who say that growth will slow by 0.5% and 1% respectively. It is due to the fact that majority of the Indians depend on the informal sector (accounting for an estimated 47 percent of the gross domestic product and more than 80 percent of employment). Businesses with solid balance sheets are currently facing liquidity crisis. A serious glut in the supply chain management is blowing up trade and commerce while some parts of rural India have already resorted to barter system.
“To sustain the demand, printing presses are printing the currency notes at full capacity so that adequate quantum of notes is available,” the central bank said in a statement. Currency notes are being airlifted from all the four currency presses to the 4,000-odd currency chests of RBI. The government has also placed an order for 2,000 tonnes of currency paper to be imported. Shortage of money supply is seriously affecting businesses. Reports point out that banks in urban areas are receiving only 75% of the required cash while some rural banks are receiving only 25% of the required cash. The India services business activity index registered 46.7 in November, from 54.5 in October, providing further leads of how the cash crunch is affecting the economy (an index reading above 50 indicates an expansion and one below that number indicates contraction).
Even though the government is working its printing presses and officials round the clock to prevent an institutional mismanagement, the country is in an extremely volatile situation. The bright side to this whole situation is the surprising positive sentiment that the Indian public has shown. Although millions of Indians wait in long queues outside banks to get their bills exchanged, none have resorted to violence. While many might attribute this to the emotional rhetoric and fan-base of the Indian Prime Minster, the peaceful struggle points out to a completely different aspect. Despite the difficulties, more than 93% of the five lakh people who participated in a survey on the Narendra Modi App have supported demonetization, the PMO reported a day after Prime Minister Narendra Modi sought public feedback on the issue. It is the fight against corruption that has driven people to participate in the nation wide operation against the corrupt.
According to a report, the wealthiest one per cent of Indians own 49 per cent of the wealth, while the top ten per cent own 74 per cent of the wealth, making India one of the most unequal countries in the world. Demonetization is one of the tough policies that the Indian public is ready to adopt for a more equal and investment-attractive India. The Consumer Confidence Index has steadily risen over the years. Narendra Modi’s vision to quadruple India’s output is currently supported and voiced by the entire country. India has touched the $300 billion FDI milestone which makes it a safe and stable economy to invest. Even though the wind is in line with the economy, it is easy to lose control of the helm in strong currents. The next few months are crucial to the functioning of the policy and investment related sentiment in the country.