Challenges and Effects of Demonetization

Challenges Effects Demonetization
Challenges Effects Demonetization

On 8th November 2016 at 8 PM, Prime Minister Shri Narendra Modi announced the devaluation of 500 and 1000 currency notes and introduction of new 500 and 2000 notes. This process is called Demonetization. Here the the few challenges and effects of Demonetization :

  1. Immediate impact is expected to be negative all round
    1. In the short term it will be a logistical nightmare to manage the cash replacement in banks and smooth functioning of the banking system
    2. Slowdown in consumer spending due to limited cash availability
    3. Severe liquidity issues in cash based sectors like Real Estate and Jewellery
    4. GDP will decline in the next 2 quarters due to reduction in overall spending
  2. Over the next 4-5 months:Those having legitimate income will deposit it in banks and apart from the initial hassles associated with the banking system, they will have nothing to worry about.However those having unaccounted money will face several problems as follows:
    1. Those who choose to do nothing with the money, their notes will expire worthless. Every note is a liability of the Government (RBI), and thus notes becoming worthless will benefit the Government by extinguishing its liability.
    2. Those who declare their unaccounted money, approx 60- 70% of the money will go to the Govt in the form of taxes and penalties.
    3. There will be a third category who will try to launder their money, but which will entail severe risks including penalties and prosecution. However, the money sought to be laundered will anyway enter into circulation and remain therein. It is expected that even if 50% of the around 14 lakh crores of old notes are legitimate, the remaining 50% or around Rs 7 lakh crores of unaccounted money will see around 60 to 80 % thereof or approx Rs 5 lakh crores coming to the government in the form of extinguished RBI liability (point a above) and taxes and penalties. This Rs 5 lakh crores is enough to take care of India’s entire fiscal deficit for one year or more.
  3. Overall Economic Impact:
    1. GDP growth is expected to be negative for around 6 months. However subsequent 2 years will see sharp “hockey stick” revival in growth.
    2. Inflation is expected to fall sharply with fall in Real Estate prices and transaction costs thereof.
    3. Government Deficit will see a huge windfall in the next 2 years.
    4. Currency is expected to strengthen as inflation drops and economy gets a boost.
    5. 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.
    6. Real Estate and Jewellery sectors, though battered initially will stabilize in the next 6 months.
  4. Effect on various Asset classes:
    1. Bond prices will rise as interest rates drop.
    2. Real Estate is expected to fall by around 20 -25 % and stabilize thereafter.
    3. 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.
    4. 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, expecially 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.

Lastly, the question may arise as to whether the new Rs 2000 Rupee notes will create more black money or not. While that is always a possibility, it should be noted that this demonetization would have created a psychological impact especially on large scale evaders who will definitely think twice before taking such action

 

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