DEMONETIZATION

DECEMBER 7, 2016
PLACEMENT PREPARATION COMMITTEE
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DEMONETIZATION | Placement Preparation Committee

The Rs.500 and Rs.1000 notes constitute around 86% of the total value of the currency in circulation.
Demonetization is expected to remove black money in form of this currency from the economy as they
will be blocked considering the holders will not be in a position to deposit the same in the banks,
temporarily halt the circulation of large volumes of counterfeit currency and curb the funding for antisocial elements like smuggling, terrorism, espionage, etc. (Black money is estimated to be between 1030% of the national income.)
Effect on GDP
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. Consumption demand forms 56% of the
GDP. This, coupled with the adverse impact on real estate and informal sectors may lead to lowering of
GDP growth in short run.
Expected impact on fake currency
A study by the National Investigation Agency and the Indian Statistical Institute, in 2016, estimated that
fake Indian currency notes in circulation have a face value of Rs. 400 crore. This is an incidence of fake
currency of 0.022%. The scale of counterfeiting of the Indian rupee is not out of line with what is seen in
other countries, and the procedures adopted worldwide to address this include investigative actions
against counterfeiters, phased replacement of old series of notes with new notes that have better security
features, etc. Demonetization is generally not seen as a tool for dealing with counterfeiting. We must
also not forget that the counterfeiters will now get to work on the new 500/2000 rupee notes, while India
will likely never do a demonetization again.
Expected impact on black money
The analysis presented in the Finance Ministry's White Paper on Black Money, 2012, shows that, on an
average, the amount of cash seized during raids by income tax authorities is 4.88 percent of total
undisclosed income admitted in those cases. This data is from more than 23 thousand warrants executed.
Even if this decision inflicted a 100% loss upon holders of unaccounted cash, this would imply a loss of
4.88% of their total unaccounted wealth, which is not much of a shock for those with such wealth. Thus,
demonetization targets only a small part of unaccounted wealth that is held in form of cash. Tackling
Black money would require immense political will and legal/administrative/diplomatic heavy-lifting. The
government needs to follow up strongly on its demonetization move.
Impact on Inflation
The RBI (Reserve Bank of India) considers the CPI (consumer price index) as its primary gauge of
measuring inflation. By January 2016, it was supposed to keep inflation below a target of 6%, which it was
able to do. Its next target is to keep inflation at or below the 5% mark by March 2017.
Demonetization is expected to have a negative impact on inflation. Consumer spending activity fell to a
near halt. Consumers are refraining from making any purchases except essential items from the
consumer staples, healthcare, and energy segments. Activity in the real estate sector, which includes a

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lot of cash and undocumented transactions, slowed down significantly, Metropolitan and Tier 1 cities
reported up to a 30% fall in house prices.
Food item inflation, measured by changes in the Consumer Food Price Index, accounts for 47.3% of the
overall CPI. Due to 86.4% of the value of the currency notes in circulation going out of the financial
system and re-monetization being slow, the supply and demand of food items fell. It will exert more
downward pressure on inflation.
However, gradually as the new notes get circulated in the market and the mismatch gets corrected,
money supply will pick up speed and hence reverse this negative impact on inflation.
Welfare loss for the currency using population
Most active segments of the population who constitute the base of the pyramid uses currency to meet
their transactions. The daily wage earners, other labourers, small traders etc. who reside out of the
formal economy uses cash frequently. These sections will lose income in the absence of liquid cash. Cash
stringency will compel firms to reduce labour cost and thus reduces income to the poor working class.
Monetary Policy
RBIs Monetary Policy Committee reduced the countrys repo rate by 25 basis points on October 4, 2016.
The rate reduced 6.3% from the said date. The combined quantum of the cuts for the year stands at 50
basis points.
Demonetization will lead to more deposits in banks in the form of savings and current account deposits.
This in turn will enhance the liquidity position of the banks, which will later be used for lending
purposes. Banks already started reducing their deposit rates. Investors in the short term will now believe
that Cash is not the safest asset and there is little point in hoarding it. This will shift them from physical
asset to financial assets where returns are also higher. Higher demand for government bonds and other
high rated bonds in a situation of tepid demands for credit, leading to lower bond yields especially in the
shorter end of the curve. Lending rates are expected to fall as well. Due to the expected fall in inflation,
the RBI will likely undertake more cuts in the repo rate.
The reduction in lending rates is expected to stoke lending by tempting consumers to take out loans for
purchasing expensive consumer discretionary items like vehicles and houses. This will improve monetary
transmission, and benefit consumersboth corporate and individual.
These rate cuts will aim to boost consumption. Any increase in economic activity due to more
consumption on account of lower rates can be beneficial to India-focused funds as well.
Impact on different sectors
The key segments of the economy where cash transactions play a vital role are real estate, gold, high end
retail and the informal sectors, which may face near term contraction as the consumers are deferring
purchases. A significant impact in the short-run will be on the daily/weekly wage employment in the
informal sector. The construction sector has one of the highest employment multipliers. Technology and
financial services are expected to gain in the medium to long term.
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In the long term, the economy will benefit from the reduction of the black money, which will lead to
higher tax collection, better business environment, less corruption & transparency. It will improve the
situation of Fiscal Deficit of the Country and hence reduce the fiscal deficit. Also, the economy would
benefit from higher government spending and greater financial inclusion and the movement of
household savings from physical to financial.
Business Investment: There will not be much impact on business investment as it is mainly a function
of interest rates.
NBFCs and MFIs: This move may create some problems as they NBFCs and MFIs have huge volumes
of cash based transactions.

The banks/ NBFCs/ MFIs who mainly receive loan and interest payments in cash will be affected
and this might disrupt the lending cycle.

LAP (Loan against Property) as a product stands at asset quality risk because of aggressive
lending practices at many banks/NBFCs where unaccounted income is taken into consideration while
deciding on income eligibility and loan amount for a borrower.

MFIs (Micro Finance Institutions) lending to rural customers without access to bank
branches/P.O.s may see some near term difficulty in collections.
Online transactions and alternative modes of payment: With cash transactions facing a reduction,
alternative forms of payment will see a surge in demand. Digital transaction systems, E wallets and apps,
online transactions using E banking, usage of Plastic money (Debit and Credit Cards), etc. will definitely
see substantial increases in demand. This should eventually lead to strengthening of such systems as the
banking habits of people are expected to improve. In less than a week after demonetization, Paytm
claimed to have registered a 700% increase in overall traffic on the platform and 1000% growth in the
value of money added to Paytm accounts. In addition, the average transaction value has increased by
200% and the number of mobile app downloads by 300%.
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.
Impact on Real Estate: Realty index crashed 11.8% on BSE, the day after announcement. Demand from
investors for real estate may come down since in some cases, investors prefer cash transactions. If the
proportion of earlier transactions in the real estate sector, which were allegedly done through partial
cash payment, reduces, the registered prices for real estate will go up. We expect the supply of real estate
in the secondary market, which is strongly rumored 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. The
situation may improve as banks may decrease interest rates and extend housing loans at attractive prices.
Impact on Gold: After an immediate initial gold buying rush on the eve of demonetization which lifted
the precious metal's prices to 3-year highs, the prices have been on a downward trend. A fall in global
gold prices, with a sudden strengthening of the US dollar after the Trump victory, also muted gold
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returns. Immediate demand outlook for the metal remains weak as cash runs dry, especially in key rural
markets which are key consumers of gold.
The prices of jewelry are expected to fall in the next two or three quarters, the unorganized sector can be
affected worse due to unaccounted inventor and high amount of cash sales. There is not going to be
much of a negative impact to jewelry exporters as they are a part of an organized market and
transactions are done, on the basis of an invoice. About 70-75 per cent of jewelers in the country are
unorganized. But 25% of the organized jewelers contribute more than 80% of the business. However, the
demonetization move will also lead the unorganized sector to get streamlined.
In the longer run, demand will rebound and benefit from the governments decision because, once fresh
high value currency notes start coming in and other restrictions are lifted, the pent up demand will drive
up gold demand in a big way, although there are many other factors impacting the precious metal.
Oil and Gas: If the rupee appreciates, companies that import crude will benefit. But again a bigger
impact for them would depend on what happens with the price of crude in the international market. The
Government and in turn it spends on infrastructure and movement of goods happen. This requires oil
(Petrol/diesel) and OMCs business to improve on healthy rates. Coupled with low PE and high earnings,
the shares might go up.
Mutual funds: In the long term, the mutual funds industry will benefit from the scrapping of 500 and
1,000 rupee notes. Banks will soon reduce the fixed deposit rates. Some banks have already reduced fixed
deposit rates. With fixed deposits offering less interest, citizens will shift money to mutual funds, to get
returns more than inflation. Investments in mutual fund schemes will increase. When interest rates are
falling in the economy, debt mutual funds do well.
Stock Market: Technical speaking it should not impact Indian stock market. Reason being NSE and BSE
from long time back have made it a mandatory to have PAN Card to open DEMAT and do any
transaction in market. Along with this both NSE and BSE have been fully digitalized and avoided any
kind of cash transaction.
There will however be a temporary setback as markets mostly operate on investor sentiments. While the
Nifty 50 fell 6.3% from November 8 until November 22, the S&P BSE Sensex fell 5.9% during the same
period. Due to the rise in the US dollar, the dollar equivalents of the Sensex and the Nifty fell more than
8% each. The S&P BSE 100 Index, which is comprised of 100 stocks compared to the Sensexs 30, fell 6.6%
during this period. Mid and small-cap indices have been hit much harder than broader market indices.
Even after a rise on November 22, the S&P BSE MidCap and the S&P BSE SmallCap indices fell 8.2% and
10.9%, respectively, in the previously mentioned period.
An elevation of uncertainty is always a negative for equity markets. The biggest negative is for the real
estate market. Consumption-driven sectors and stocks will continue to be hit in the short term. Markets
will recover in the medium-term as the uncertainty eases out. The long-term outlook remains positive.
Agriculture: Agriculture is impacted through the input-output channels as well as price and output
feedback effects. Sale, transport, marketing and distribution of ready produce to wholesale centres or
mandis, is dominantly cash-dependent. The disruptions in the supply chains feedback to farmers as a
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decrease in sales, increased wastage of perishables and lower revenues that show up as trade dues instead
of cash in hand.
The input side is equally affected as many payments/purchases, such as seeds, fertilizers, implements
and tools, are outright in cash. Borrowing-financing operations of larger farmers and organized
producers are also cut off or severely clipped. Lower cereals, oilseeds outputs would persist until the next
harvest, or about nine months and it is certain that incomes and profit margins will be hurt. Price and
output effects will reflect all the above listed factors. This means considerable fluctuations, increased
uncertainty and risk.
Steps taken by government to aid farmersi.
Farmers could purchase seeds with old high-denomination notes of Rs 500. farmers could
purchase seeds from any government outlet on production of proof of identity. The notification said that
this revised rule was being put in place in order to support farmers harvesting the current Rabi crop.
ii.
RBI also provided an additional 60 days for repayment of housing, car, farm and other loans
worth up to Rs 1 crore. This is applicable to loans payable between November 1 and December 31.
iii.
The Centre is considering putting money into cooperative banks and then disbursing it through
organizations such as NABARD (National Bank for Agriculture and Rural Development) to help people in
far-flung rural areas.
iv.
The government also increased the cash limit withdrawal for farmers to Rs.25,000 per week from
their Know Your Customer (KYC) compliant accounts subject to the normal loan limits and conditions.
Retail: Retail sector will be one of the worst hit sectors in the short run as 68% of the total transactions
in the economy are cash based. As Indian retail segment generates a lot of cash transactions, there might
be reduction in the sales over the next one or two quarters. However, the impact is felt more by the small
traders and the unorganized retailing segment, rather than the organized retailers.
Some sectors like jewelry and the luxury segment have been impacted more than others and will take
much longer to revive. However, the use of plastic money and transactions through online payments will
continue to release the money into the retail market.
Demonetization has resulted in visibly reduced low footfalls in shopping malls, but this effect is
temporary and will turn around in few weeks as more currency circulates in the system and improves the
purchasing power and appetite of the consumers.
In the medium-to-long run, domestic consumption will be stable owing to Indias strong economic base
and favorable demographics. Also, as more retailers encourage alternative/digital payment solutions, the
market ecosystem will become more transparent and structured going forward.
The long-term growth story of the Indian retail sector continues to be one of resilience and growth.

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Automobile: There will be a temporary disruption in the auto industry in the near term due to the ban
on currency notes. But a larger impact will be in the rural markets as the number of cash transactions is
high. Motorcycle sales in the rural areas could also slow down since a majority of two-wheelers here are
bought with cash. Besides, two-wheelers are exempt from disclosure of PAN which is mandatory for
larger vehicles. Sales of luxury cars and premium SUVs, along with the unorganized used car market
could also witness a temporary slump due to the demonetization. Passenger vehicle segment could face
less heat as close to 75-80% of the sales are either through financing or payment through cheque.
Power: Demonetization has turned out to be a positive event for the power sector with distribution
companies recovering pending power bills from their customers. The government has mandated that the
old notes of Rs 500 and Rs 1,000 denominations can be used to pay pending utility bills which will help
discoms due to their huge backlog of unpaid bills. Since the announcement of demonetization, discoms
in the state have seen payments of old bills cross Rs 1 billion ($ 14.74 million) within a week. Power sector
could also benefit from relaxed lending and lower rates.
e-Commerce: The recent government push towards a cashless economy will encourage more online
payments and reduce the total share of COD in e-commerce sales from the current high of nearly 80% of
total transactions. This should help e-commerce companies including Amazon to reduce overhead costs
and other risks associated with the COD model. However, initially, in the next 1-2 months it may hurt
ecommerce companies. About 40% of CoD was driven by black money according to a study done two
years ago. This will have a serious impact on GMV as not all CoD will convert into digital payments.
Amazon has reported 10-fold jump in customers opting for e-payments after immediate short term
impact. Even smaller players in the E-commerce industry like Big Basket, Grofers have seen considerable
increase in traffic.
Future Challenges:
1.

Unchecked Corruption will lead to fresh generation of black money.

2.

Future Tax evasion would mean that a lot of money could go unaccounted for.

3.
Continuance of Cash dealings in sectors like gems & jewelry, real estate could be used to convert
black into white through Benami transactions.
4.
Black money stashed abroad still to be brought under the tax net. This could be moved through
pre-existing channels back into the system.
5.
The demonetization act might also lead to slow down in investment as people will hoard their
wealth in unproductive assets which might become hindrance for the government to take strict actions
in the demonetization act.
6.
Crony capitalism- Crony capitalism is a term describing an economy in which success in business
depends on close relationships between business people and government officials. It may be exhibited by
favoritism in the distribution of legal permits, government grants, special tax breaks, or other forms of
state interventionism.

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7.

The higher currency notes may make hoarding easier.

Measures to improve:
1.
Zero-tolerance against corruption. Need to ensure strict surveillance in government offices and
ensure strict time-bound action against erring officials.
2.
A robust tax-compliance system to make evasion difficult. GST is expected to play positive role in
this regard.
3.
Making PAN compulsory for cash transactions above a certain minimum point. Legislations like
Benami Transactions Act, black Money prohibition act will prove useful.
4.
DTAAs with foreign nations need to be concluded quickly and an all out effort needs to be made
to extradite proclaimed offenders.
5.
Strict checks on purchases of gold and only allowing cash for transactions upto a certain limit
without Pan card.
6.

Pushing ahead digital transactions.

7.
Strict surveillance, more awareness in people, new steps to get black money from gold and realestate sector.
8.
Less penalty in direct tax, late tax submission to increase tax base, decrease in litigation through
conciliatory approach. The government should take steps to promote increased tax compliance. This can
be done by making filing of returns easier, benefits for honest taxpayers.
9.

Scrutiny of Jan Dhan accounts as there is a sudden increase in the amount of inflow in them.

10.
etc.

More focus on digital literacy and to spread awareness about financial inclusion, financial literacy

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