Demonetization – NDA’s Smart Move Towards Dismantling The Parallel Economy

On the 9th of Nov, 2016, the NDA Govt came out with an announcement of the discontinuation of the Rs 500 and 1000 currency notes. The news created great discomfort and unrest amongst the people. The move was in the wake of increasing black money and counterfeit notes in circulation. The topic is of immense interest since this move is going to impact the several sectors of the economy and the way policy decisions are approached. I would like to bring out the overall meaning of the parallel economy, the causes, the key commodities which lead to the creation of the parallel economy, the cost that RBI will have to bear because of the decision and further a set of comments on the cost-benefit analysis of the decision from a central bank perspective in this blog. In addition to the above, I would also like to bring out the effects of the Govt’s decision on the near future RBI Monetary policies in the context of the rate and the liquidity, the likely near-term effects on the stock markets, liquidity management of the banks, the effects on real estate, MFIs etc. Let us look at the overall situation and a quick impact analysis on the same.

The parallel economy has been a critical pain point for the NDA Govt to function smoothly. A Parallel economy, based on the black money or unaccounted money, is a big menace to the Indian economy. It is also a cause of big loss in the tax revenues for the government. The Indian economy has grown by 30% in the last 5 years whereas the high value denominated notes have gone up by around 90%. This essentially indicates that the transactions which take place are largely in cash and are unaccounted for and that eventually leads to a creation of a parallel economy and all such transactions do not contribute to the net GDP thus creating hindrances to the growth rate. In order to take a stance against this, the NDA Govt decided to discontinue the old currency notes and replace them with new so that the parallel economy transactions reduce significantly or might come to a stand still in a bit.

Key cause of Parallel economy creation:

  1. Tax Evasion
  2. Cash transaction in trade and services
  3. Corruption
  4. Equity market manipulations
  5. Real Estate etc

Key Investment Avenues for such lump sum cash:

  1. Gold
  2. Informal lending/deposit market
  3. Real Estate


Effects on the Monetary Policy:

The Reserve Bank of India may have to change the policy course amidst removal of high value notes as the huge accretion in deposits will increase the overall liquidity in the system. In this situation, the RBI might have to sell out bonds to suck the additional liquidity in the system. The high liquidity in the system shall lead to cheaper loans thus boosting inorganic growth. RBI may want to minimize such impact if any. The additional CASA deposits shall lead to low rate deposits thus leading to cheaper lending with a lagging effect of about 2 quarters.

Sectoral Effects on the Economy:

  1. Real Estate – With lower interest rates in the near future and a liquidity crunch in the real estate sector, home prices might come down by about 20-25% in the medium term.
  2. E Commerce – Reduction in cash transactions has already forced amazon and flipkart to discontinue their cash on delivery services thus impacting their reach and business in terms of the overall sales.
  3. Infrastructure – The sector might face immediate heat since most of the payments to the labourers are made in cash
  4. Agriculture – Agri might face immense negative impacts since the trade largely is carried out on cash basis including the purchase of seeds and fertilizers. However, the impact will be short-lived.
  5. Housing Finance Companies – Sector finance companies shall have opportunities for higher demand amidst lower home prices. However, it might face the heat in terms of the overall credit quality where the lending has been largely for low-income groups.
  6. Banking – Banks/NBFCs shall be benefitted since a large sum of low-cost deposits in the form of CASA accounts shall be accumulated. However, liquidity management and efficient operations shall continue to pose challenges to the banking institution at least till December.

Market Outlook:

The markets shall continue to be volatile in the short-term and significantly jittery in the medium term. The markets are yet to price in the effects of the sudden decision but we can the markets to neutralize by the end of the month. However, the long-term outlook shall be bullish as far the demonetization impacts are concerns. Ultimately, the markets will take their own course based on the likeliness of the future events. Nifty should rise back to the 8500 levels by November end is the majority consensus so far.

Cost Benefit of De-monetization (RBI Perspective):

Total Cost of Printing Vs Demonetization Benefit Comparison

What the above numbers mean is that the cost for RBI to print new notes shall be close to Rs 62 Billion. The Govt, on the other hand, has targeted to demonetize around 170 Billion. Assuming 100% success, the Govt shall be demonetizing close to 170 billion which is as good as three times the cost the Reserve Bank shall bear to make a smooth transition. It largely is a benefittin trade-off for the Govt as well as the RBI.

The decision of the NDA Govt is one of the most prominent moves of the decade towards making India a better country in terms of growth and transparency . However, the approach of the Govt in handling this chaotic situation smartly will drive the near future results. The Reserve Bank on the other hand, will have to make sure they keep mopping up the additional liquidity in the system and intervene when required to ensure the financial stability of the system. India has clearly welcomed this decision as far as the reactions all over are to be considered. It will be challenging to see the handling of the outcomes that evolve from the decision taken. Hopefully, this should be the fresh start towards making India a more transparent, efficient and the fastest growing emerging economy. If not complete eradication, this will definitely reduce the overall impact of the parallel economy and transfer the reduction as a contribution to the real economy growth rate. I hope as citizen, we will make an effort to ensure the new notes being printed are not soiled by writing on them or keeping them in unhygenic conditions as it adds huge cost to the Govt and the Reserve Bank.

I would love to know the diverse views of the readers as well. Thank you. :).