Who Gains, Who Loses In Government’s Demonetisation of Rs 500 & Rs 1,000

Macroeconomists and financial accountants are having a ball with demonetisation. Neither group is certain how demonetised notes which don't come back for destruction will impact the Reserve Bank's balance-sheet, and, more importantly, its profit and loss account. Profits can be transferred to the government as dividends.

If some notes remain outstanding (a 100 percent exchange is most unlikely), the RBI's liabilities surely will come down. Does this mean it can declare a profit on the amount it does not owe to old currency note holders, and adjust its books accordingly, declare a profit and transfer the bonanza to the government? Or will it merely adjust the drop in its liabilities by showing an increase in its non-monetary liabilities, or make a balancing reduction in assets to yield no direct benefit to the government? At best the RBI can return the government bonds it holds back to government to reduce its assets, and the latter can reduce its borrowing costs by paring down its future borrowing requirements this fiscal.

And how will demonetisation impact the growth rate, the government’s coffers, banks’ balance-sheets, interest rates, the exchange rate, corporate profits, the stock markets, and specific sectors? Here are our best guesses. But demonetisation is a complex issue, and will take some time to play out. So don’t rule out unexpected outcomes.

GDP growth: In the short term, due to the cash crunch and downtrend in everyday transactions, one can expect a quarter or two of slower growth. Let’s also remember, tax-evaded money boosts demand. Now that cash-based black money is in decline, consumption demand will weaken. The October-December quarter growth will certainly be impacted aversely by demonetisation. And maybe even the January-March quarter.

Interest rates: The sudden surge in cash inflows of old currency notes, spurred by demonetisation, will increase bank deposits and enable a reduction in interest rates. Since this money will force banks to invest in government securities for maintaining SLR (statutory liquidity ratio), it will also depress bond yields. But in the informal money market, the shortage of cash will push up interest rates in the short run. But once all the demonetised notes are exchanged, new notes will take their place. The deposits will flow out. This process may take two to three months.

Fiscal deficit and tax revenues: If a lot of the black money held as cash tries to get back into the formal books of businesses, and reported profits grow, government tax revenues will surge. If the RBI makes some kind of killing by writing off notes that don’t come back for destruction, it can pass on some of the profits, too. Excess deposits in bank accounts that are abnormal may also face penal taxes. This additional revenue will enable Arun Jaitley to quickly recapitalise banks and resume the lending cycle, not to speak of increasing infrastructure spending.

But there is another side to the story. The deceleration in trade and business turnover due to demonetisation – lots of small vendors, kirana merchants, and small businesses will see a fall in sales – may mean lower indirect and direct taxes in the current quarter and the next. Tax revenues will be adversely impacted. Netting out the surge in profits from illegal money coming back to the balance-sheet and the depressing effect of demonetisation on consumer transactions, the government’s net revenue gain may be relatively small in the end.

Broadly speaking, Jaitley should be prepared to offer a small reflationary package to consumers and businesses to get growth revving up again. Demonetisation has been wrongly timed for India Inc which is only now recovering from its balance-sheet recession.

Exchange rates: The rupee-dollar rate can go either way. If cash is short for an extended period of time, the rupee will strengthen against the dollar. But the RBI may have to buy dollars in order to infuse rupees into the system. So the rate could go either way, and may ultimately be determined by long-term portfolio inflows or outflows. A short-term fall in GDP growth may also keep import demand for dollars down, weakening the dollar.

Corporate profits: A deflating economy will dampen corporate profits – postponing what experts thought was a slow revival in profitability. This may delay the revival of the investment cycle. Broadly speaking, demonetisation is not good for the corporate sector.

Banks: Banks will benefit from the increase in deposits and the fall in yields, which will enable them to write off bad loans more quickly and report higher treasury. This is one reason why bank shares have held up. However, the need to pump more cash through branches and ATMs means higher operating costs for them in this quarter. But the gains may be more than the losses.

The RBI: The RBI will end up spending around Rs 11,000 crore for printing new Rs 500, Rs 2,000 and Rs 100 notes. But it will probably make up this cost by higher earnings from decommissioned notes. In 2015-16, the RBI’s expenses were Rs 14,900 crore and income Rs 80,870 crore. Costs will double this fiscal due to demonetisation, but earnings from liabilities extinguished should more than compensate. The government can expect a higher dividend next year.

Stock markets: There is no reason for the stock markets to do particularly well when corporate profits may be under a cloud. But if banks do better, the indices should be about even in the short term. Banks have a large weight in the indices.

Sectors: The real estate sector will be worst hit, for this is where cash transactions are maximum. One can expect prices to come down, and if the government takes more steps to reduce benami ownership, one can expect a significant price correction. This will help new buyers, but home loan beneficiaries will find the collateral value of their homes down, and banks may have to either accept lower value collateral or seek a faster repayment.

The transport and logistics sector, which brings essentials to cities, is largely impacted by the cash crunch, with less essentials being moved in the short run. This may impact retail prices for a while.

It is the unorganised retail sector and the self-employed – who depend most on cash transactions – which will be worst affected. This is why injecting lots of cash into the system is vital to ensure that the dip in economic activity is not prolonged.