Economic implications of the ban on INR 500 and INR 1000 notes

Insights

Ban on INR 500 and INR 1000 currency notes

Economic implications

The government has pulled off arguably one of the most significant reform measures in its tenure. While this expeditious move to boldly counter the black money and parallel economy threat is likely to have significant repercussions, this effort will, more importantly, have a visible impact on how the current government's policies are perceived in international circles of economic power.

Impact of Demonetization

Most of the macroeconomic impact will be felt in the short term, though there are larger implications in the medium to long term. Our views on more immediate questions follow:

What are some of the short term impacts?

There will be a disruption in the current liquidity situation as households are likely to get affected by the note exchange and currency withdrawal terms laid by the government. Though clarity is unfolding on this, commodity transactions and general cash market transactions are likely to feel an immediate impact. 

Unorganised sector proceedings including small trade market activities will remain volatile in the short term. Roadside vendors, cab drivers, kirana stores, etc., have already stopped accepting INR 500 and INR 1000 notes. It is important to note that a significant percentage of the Indian workforce, employed in this sector, is likely to be affected by immediate liquidity issues. Overall, a likely negative impact on disposable income is expected along with disruption in the consumption patterns of the general populace.

It is estimated that there may be a negative GDP impact in the current quarter as consumption shock gets transmitted in the system. However, the quantum and degree of this impact cannot be ascertained at this time.

How are the equity markets likely to be affected?

An elevation of uncertainty is always a negative for equity markets. As such, markets have reacted negatively to this latest news though part of this may be attributed to the US election results. Markets will recover in the medium term as the uncertainty eases out. While there exists a possibility of a broad based decline, there will be some sectors (with linkages to the unorganised economy) that would feel the brunt while some niche technology sectors related to fintech and e-commerce could gain. The long term outlook remains positive.

What could be some of the sectoral impacts?

While sectors with linkages to the unorganised economy are likely to be affected, technology and financial services are expected to gain in the medium to long term. On a sectoral basis, the commodities and agricultural sector, including the market for consumer durables and non-durables, is expected to feel the heat. In the short to medium term, large denomination purchases will likely be made via electronic purchases rather than through brick and mortar outlets. This will impact the retail sector adversely. The real estate sector is likely to see a significant negative impact in the medium to long term particularly in the repurchase market. There are expectations of a revaluation of current real estate transactions across the board representing possible losses to players in the sector. The luxury goods market is also likely to get affected as this move represents an erosion of real wealth to a large number of people. Areas of sub-sectoral impact will be felt in luxury cars, SUVs, gems, jewellery, gold and high-end branded products.

On the positive side, there is likely to a reset of spending patterns as this move indirectly represents a significant push towards a cashless economy. Businesses in the fin-tech sector including payment banks, mobile wallets, electronic transfer providers, etc., are expected to see gains.

Positives:

  • E-commerce and Fintech

1) Payment gateways

2) Cards

3) Mobile wallets

4) Online retail 

5) Net and payment banks

6) e-marketplace 

Negatives:

  • Agriculture
  • Luxury goods
  • Real Estate
  • Commodities
  • Traditional Retail

1) Consumer durables

2) Consumer non-durables

Will exchange rates be affected?

We could see some appreciation of the domestic currency in the forex markets as notes in circulation will decrease. Though the RBI will be monitoring and taking remedial action, negative impact on international trade cannot be ruled out at this point. Counter moves by the government are expected to ease this impact.

Will there be an effect on inflation and what are the policy implications for it?

We are likely to see some decline in inflationary pressures as demand along with household inflation expectations are likely to go down. This would make RBI more comfortable on managing inflation in the future increasing the possibility of rate cuts in the future.

What are some of the longer term implications?

This essentially represents a change in regime for the real and financial economy. Domestically, there could be some turmoil as the effect will be disproportionately felt by the lower and upper income classes. Internationally, the government is likely to get a thumbs up for the move and more countries could potentially see this as a viable option to curb black money and stem illegal financial activity. 

Lastly, though this move by the government may not be a first (having being tried by earlier governments as a tool to fight corruption), such an action achieves larger significance for a globally connected India as it shows boldness in tackling an issue which has remained a thorn in the growth success story of this generation.

To learn more about the implications of this reform, get in touch with:

Anis Chakravarty

Lead Economist,

anchakravarty@deloitte.com

Richa Gupta

Senior Economist,

richagupta@deloitte.com

Rishi Shah

Economist,

shahrishi@deloitte.com

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