Demonetisation and growth

Indian markets witnessed a fall partly due to emerging markets sell-off after the Donald Trump victory and announcement of demonetisation of high value notes by the Indian government.

Donald Trump’s election in the US has strengthened market expectations of rate hikes in the US, and the shift of growth mantle from monetary policy to fiscal policy. We had been increasingly getting skeptical of incremental efficacy of global monetary easing. The money-pumping exercise had been leading to asset prices reflation but without a commensurate impact on real economy. Stagnant real incomes and rising income and wealth inequality in developed market led to increased discontentment among the population at large. There are fears that the best of globalisation cycle and liberal policies is behind us.

Over the last two months, dollar has strengthened and bond yields across the globe including in emerging markets have risen sharply. Given the depreciation in other emerging market currencies, the rising crude prices and strengthening dollar, rupee has the potential to weaken further.

To gauge the impact of demonetisation on growth, one needs to distinguish between liquidity, wealth, and income effect. Loss of demand due to liquidity effect or as one would put it ‘unavailability of adequate quantum of rupee notes’ would be transient and can be recouped to a large extent. Withdrawal of specified banking notes (SBN) from the system has also led to erosion of wealth for higher income sections of the society and to that extent may permanently impact the sectors which profoundly depend on demand from high income group. That said, in aggregate, the wealth effect might cancel itself in aggregate since one section of society would gain at the expense of the other. At last, consumption lost because of underlying incomes taking a hit may not necessarily be recouped. That said, the demonetisation coupled with GST and other measures to improve India’s governance are structurally positive for Indian growth story.

While the stated objectives of withdrawing specified banking notes was to curb the ‘fake currency’ generation which fund host of illegal activities (like terrorism) and black money in India, the exercise has had unintended consequences to the Indian political, social and economic machinery. Apart from disrupting the business activity, it led to constrained consumption and potential balance sheet issues for household and businesses. We are into an uncharted territory and the clarity of future policy decisions has been marred, which makes businesses postpone their investment decisions. Some of the sectors such as high end discretionary goods and services and real estate could be hit due to wealth effect. While government finances may benefit from better tax compliance, there could be adverse effect on indirect tax collections due to growth slowdown apart from the cost of this exercise to the RBI and the government.

The RBI has clearly opined that the cancellation of legal tender status of SBNs does not automatically cancel RBI’s liability. This may nullify the hope of any near-term one time dividend transfer acting as a one-time fiscal bounty for the government, even though (for longer-term), we refrain from concluding on that with certainty, as of now.

The demonetisation exercise has significantly catalysed the vision of the policy makers to achieve financial inclusion process, lower cash utilisation for transactional purposes (a move towards ‘cashless economy’) and to push forward the households towards financial products for savings (financialisation of savings). These achievements enhance the operational and cost productivity of the economy which may not be captured in linear projections of demand and supply.

Better tax-compliance and the increased government revenue on sustainable basis can enhance the infrastructure investment by the government.

Move towards a cashless economy will then ensure the lower cost and traceability of transactions and detecting the discrepancies between a person’s actual income and their transactions. Basically, all said and done, longer-term gains depend on the followup reforms. The present move of demonetisation has laid its axe on the stock of black-wealth. The measure in itself does not deal with the generation process of black money. This is a long drawn battle and the present government seems to be determined notwithstanding the near term pain.

In the equity markets, Sensex is down 3 per cent since 8 November. Performance down the capitalisation curve worsened with the BSE midcap index and the BSE smallcap index underperforming the large cap Sensex by 2.8 per cent and 4.5 per cent, respectively. The FIIs sold equities worth US $2 billion which was well-matched with significantly higher buying by the domestic institutions. The valuations have corrected and are its long-term average of 16 times forward earnings. The impact of demonetisation is likely to sustain for more than a quarter or two but given that there are too many moving parts, its bit too early to make any call on it. While the disruption in economic activity particularly on discretionary consumption is likely to drive sentiments, one must not lose sight of the fact that a good part of index earnings (technology, healthcare, oil and gas, consumer staples, telecom, global commodities etc.) are likely to remain largely insulated. Global trade is tilted towards an upward direction and the Indian exports have also been inching higher for last few months. Barring the risk of a deeper slowdown leading to systemic balance sheet issues, the ‘digitalisation of finance’ and the ‘financialisation of savings’ actually augur rather well for financials (almost 30 per cent of index). The market correction is offering an entry opportunity to investors with a view towards long term horizon. Dark clouds are always followed by a shining sun. This time won’t be any different.

Watch out for

• Performance down the capitalisation curve worsened with the BSE Midcap index.
• Sectors such as high end discretionary goods and services and real estate could be hit due to wealth effect.

Navneet Munot is CIO—SBI Mutual Fund

olmdesk@outlookindia.com