The

Demonetization
Effect

Submitted To:
Submitted By:
Yogesh Yadav
MBA Sem. 3

Subject: Management of Financial Services

B.K. School of Business Management

120 Feet Ring Road, Gujarat University, Navrangpura, Ahmedabad, Gujarat 380009

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Event Update
The move by the government to demonetize Rs.500 and Rs.1000
notes by replacing them with new Rs.500 and Rs.2000 notes has
taken the country with surprise. The move by the government is to
tackle the menace of black money, corruption, terror funding and
fake currency. From a market perspective, we think that this is a very
welcome move by the government and which has taken the black
money hoarders with surprise. The total value of old Rs.500 and
Rs.1000 notes in the circulation is to the tune of Rs.14.2 trillion,
which is about 85% of the total value of currency in circulation. This
means that the total cash has to now pass though the formal
banking channels to get legitimacy.
The World Bank in July, 2010 estimated the size of the shadow
economy for India at 20.7% of the Gross Domestic Product (GDP) in
1999 and rising to 23.2% in 2007. Assuming that this figure has not
risen since then (quite unlikely though) and that the cash component
of the shadow economy is also proportional (it could be higher), the
estimated unaccounted value of the currency could be to the tune of
Rs.3.3 trillion. Now, post the announcement of demonetization by
the government this money would have to either account for by
paying the relevant tax and penalties or would get extinguished.
There are higher chances of larger proportion of this unaccounted
currency getting extinguished as the tax rate and subsequent legal
issues could be prohibitively high for such money.

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The positive macro benefits of this move by the

government
This move by the government is likely to have long term benefits for
the economy. The extinguishing of the major proportion of
unaccounted currency would reduce from the liabilities of the
government and would add to its finances. This can have very strong
implication as the government would get money to spend without
borrowing from the market. This would mean that while interest
rates can be low, the government spending on large infrastructure
(we assume that the government would use large proportion for infra
spending) projects would kick start capex cycle and push economic
growth higher in the medium term. The move is also likely to have a
habit changing impact in the Indian populous and there could be
increased belief of keeping cash in the banks rather than stashed at
home and use formal banking channels for their spending needs.
With a large part of the cash moving through the banking channels,
the banking sector is likely to be flush with funds in the near term
and this would help them reduce cost of funds for such period. Also
with more money being kept in the banking channel, some of these
low cost deposits may be sticky and improve the medium to long
term Current Account and Savings Account (CASA) ratio of the
banks. Another element of the demonetization would be reduction in
cash transactions in real estate. This is likely to reduce to real estate
prices and make it affordable to some extent. This may be visible
more in the rural belt, where many non-farming entities purchase
fertile farmland, not for farming but for money parking purpose.
The demonetisation and consequent reduction in shadow economy
would bring the demand for such farm lands down. This move is
likely to lead to better tax compliance, raise the Tax to GDP ratio and
improved tax collection. This could lead to lower borrowing and
better fiscal management. Also with lower cash transactions in the
near term, inflation may see downtrend in the near term. Also with
higher tax to GDP ratio, the government may also get enough
headroom to reduce the income tax rates, which can lead to higher
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disposable income with people and can improve consumption

demand in the medium to long term.

However there could be near term challenges

In the immediate term, the reduced ability of the unorganized sector
to deal in cash would impact the demand. Consumption items which
had large element of cash dealing involved may see lower demand.
Real estate and allied sectors may see near term to medium term
negative impact. This HDFC Bank Investment Advisory Group may
also lead to corporate earnings getting impacted in Q3FY17, as a
large part of the old currency gets extinguished and takes time for
fresh money to come into circulation.
We will see some of the impacts of demonetization on the following:
Equities
Debt
Various Asset classes
(Gold, Bonds, Real Estate)
Overall Economic Impact
(Immediate and over the time)

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EQUITIES
The day after the demonetisation move was announced and Trump
won the US presidency, the BSE Sensex opened with a massive loss
of 1,300 points, but recovered later. It rallied on 10 November and
reported net gains for these two days of trading, only to tank 700
points the next day. Should you be worried? The global unfolding of
these two events and the market jitters created by them presents a
value buying opportunity, says Dhananjay Sinha, Head, Institutional
Research, Emkay Global. However, the impact of these events is not
over and investors shouldnt ignore them. The ripple effects of
demonetisation cannot be understated. There are major industries in
India that thrive on a parallel economy funded by black money,
says Ritesh Jain, CIO, Tata Mutual Fund. Though the government is
exchanging old notes with the new ones, it will still squeeze the
currency circulation in the short term. There may be a negative
impact on the GDP in the Oct Dec quarter, as consumption shock
gets transmitted into the system. Some rupee appreciation in the
forex markets is also expected as notes in circulation will decrease,
says Anis Chakravarty, Lead Economist, Deloitte India. If the RBI and
the government dont step in to ease the liquidity situation, our
export oriented sectors may suffer.
Lets take a closer look at specific sectors, starting with real estate. It
is best to avoid realty stocks as the sector will be among the worst
affected by the demonetisation move. The housing finance sector,
consequentially, will also be under pressure. Housing finance
companies are likely to witness some stress on loans given to real
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estate developers who are likely to face a liquidity crunch in the

short term.
Since most of the cash in circulation now will be converted to bank
deposits, banks will be the biggest beneficiaries of the
demonetisation move. We expect banks to benefit because of more
deposits, especially low cost deposits, says Rao. Though all banks
will benefit from this, investors should focus on banks such as HDFC,
ICICI that are strong on technology and can leverage the ongoing
changes to their advantage.

DEBT
With the rupee remaining relatively stable, the debt market has
reacted positively to both Trumps victory and the demonetisation
move. Bond prices may remain elevated as the flight to safety
would continue, says Sharma. This is because of the deflationary
impact of demonetisation. We are likely to see some decline in
inflationary pressures as demand comes down in the short term,
says Anis Chakravarty, Lead Economist, Deloitte India. This will also
keep prices in check as the ability to hoard commodities and other
assets will be greatly reduced, says Murthy Nagarajan, Head, Fixed
Income, Quantum Mutual Fund. Improvement in government
finances due to shift of the black economy to whiteincreased tax
compliance and better revenues for government is another
positive aspect. The debt market has also started expecting further
rate cuts, which, again, is good news for debt investors. With the
household inflation expectations coming down, the possibility of rate
cuts is increasing, says Chakravarty. Experts expect a 5075 basis
points rate cut in the next 69 months.

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Various Asset Class

a. Bond prices will rise as interest rates drop.
b. Real Estate is expected to fall by around 20 -25 % and stabilize
thereafter.
c. Effect on Gold is a bit uncertain, and may be neutral/ negative.
Lower black money will depress demand, but at the same time Gold
is a hedge against uncertainty and those still wanting to park black
money may prefer to put it into Gold instead of cash.

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d. Equity is expected to benefit the most due to three reasons. One,

there will be a gradual shift from physical assets (real estate/ Gold)
to financial assets. Two, the organised sector (corporates, especially
listed ones) will benefit due to less cash transactions. Lastly, lower
inflation and interest rates will benefit listed corporates through
lower borrowing costs, thereby increasing their profitability and
valuations.
Thus Asset Allocation and re balancing thereof will now play an
even more important role, making proper financial planning
imperative.

Overall Economic Impact

a. GDP growth is expected to be negative for around 6 months.
However subsequent 2 years will see sharp hockey stick revival in
growth.
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b. Inflation is expected to fall sharply with fall in Real Estate prices

and transaction costs thereof.
c. Government Deficit will see a huge windfall in the next 2 years.
d. Currency is expected to strengthen as inflation drops and
economy gets a boost.
e. Banking System will get a boost, as around Rs 7-8 lakh crores
base money (new legal money) will enter the system, which will
further create around 3-4 times more money due to re-circulation.
f. Real Estate and Jewellery sectors, though battered initially will
stabilize in the next 6 months.

Immediate impact: is expected to be negative all

round:
In the short term it will be a logistical nightmare to manage the
cash replacement in banks and smooth functioning of the banking
system
Slowdown in consumer spending due to limited cash availability
Severe liquidity issues in cash based sectors like Real Estate and
Jewellery
GDP will decline in the next 2 quarters due to reduction in overall
spending

Other Impacts
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 Effect on parallel economy The removal of these 500 and 1000

notes and replacement of the same with new 500 and 2000 Rupee
Notes is expected to - remove black money from the economy as
they will be blocked since the owners will not be in a position to
deposit the same in the banks, - Temporarily stall the circulation of
large volume of counterfeit currency and - curb the funding for
anti-social elements like smuggling, terrorism, espionage, etc.
Effect on Money Supply With the older 500 and 1000 Rupees
notes being scrapped, until the new 500 and 2000 Rupees notes
get widely circulated in the market, money supply is expected to
reduce in the short run. To the extent that black money (which is
not counterfeit) does not re-enter the system, reserve money and
hence money supply will decrease permanently. However
gradually as the new notes get circulated in the market and the
mismatch gets corrected, money supply will pick up.
Effect on various economic entities with cash transaction
lowering in the short run, until the new notes are spread widely
into circulation, certain sections of the society could face short
term disruptions in facilitation of their transactions. These
sections are: Agriculture and related sector Small traders SME
Services Sector Households Political Parties Professionals
like doctor, carpenter, utility service providers, etc. Retail outlets
Effect on 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 increase in demand. This should
eventually lead to strengthening of such systems and the
infrastructure required.

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Views
From an equity market perspective, this move would be positive for
sectors like Banking and Infrastructure in the medium to long term.
This could be negative for sectors like Consumer Durables, Luxury
items, Gems and Jewellery, Real Estate and allied sectors, in the
near to medium term. This move can lead to improved tax
compliance, better fiscal balance, lower inflation, lower corruption,
complete elimination of fake currency and another stepping stone
for sustained economic growth in the longer term.
In spite of the initial hiccups and disruptions in the system,
eventually this change will be well assimilated and will prove
positive for the economy in the long run.
Black money hoarders will definitely lose out, eventually boosting
the formal economy in the long run.
Short term fall in real estate prices might benefit middle class
citizens.

This move by the Government along with the implementation of

the GST will eventually make the system more accountable and
efficient.

Bibliography
Demonetization and its impact report by HDFC Bank Investment
Advisory Group
http://economictimes.indiatimes.com/wealth/invest/howdemonetisation-move-and-donald-trumps-victory-impact-yourinvestments/articleshow/55384579.cms

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 http://www.careratings.com/upload/NewsFiles/SplAnalysis/Effects
%20of%20Demonetization%20of%20500%20and
%201000%20notes.pdf
http://www.blog.sanasecurities.com/demonetisation-impact-stockmarkets/
http://www.brameshtechanalysis.com/2016/11/challenges-andeffects-of-demonetization/

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