The demonetisation-driven cash crunch that is playing out in India will create short-term economic pain for long-term gain. This move by the central government on November 8, 2016, will trigger three sets of effects as described below.
Effect 1: The transactional hit created by a hard cash deficit
The decision to demonetise the Rs 500 and Rs 1,000 notes has created an immediate impact in terms of creating a shortage of hard currency. Data suggest that around 85 per cent of all transactions in India (by value) tend to be executed in the cash form. Hence, if you suck cash out of the Indian economy on such a scale, an economic pullback becomes all but inevitable.
To complicate matters, a cash deficit of Rs 8.5 trillion is likely to materialise in Q3FY17 as the pace of cash disbursals does not keep pace with the overnight destruction of Rs 14 trillion of currency.
The reasons for the slower cash disbursals are threefold, namely, (1) the quantitative limit of Rs 24,000 per week per person on currency withdrawals; (2) the need to re-configure ATM cassettes to be able to vend the new Rs 2,000 note (which is larger than any of the notes that are currently in circulation in India) means that the existing ATMs cannot be used to seamlessly replace the cash value that has been demonetised; and (3) physical constraints on printing cash.
Thus, in a cash-based economy where about 85 per cent of transitions materialise in the form of cash, a cash deficit to the tune of Rs 8.5 trillon or 5.7 per cent of GDP is expected to materialise in Q3FY17 and continue into Q4FY17 (albeit to a lesser extent). This then is bound to have a paralysing effect at the economic activity levels in the short term.
Even as the impact of effect #1 will be lethal, we expect this impact to be transient and its intensity to abate by Q4FY17 as banks are able to gradually reconfigure ATMs and the RBI is able to print more notes and simultaneously increase cash-withdrawal limits.
Effect 2: The structural hit (1) to non-tax-paying businesses that become unviable and (2) to the real-estate sector
The decision to demonetise Rs 500 and Rs 1,000 notes is part of the Modi-led government's broader agenda to boost tax compliance in a country characterised by large-scale tax evasion. Furthermore, a series of tax-related raids are expected to be functionalised by the government in a bid to create a credible threat of penalties for tax evaders. Besides GST implementation, the transition of the economy towards an economy that is less cash-driven (and one that creates a paper trail) is likely to result in a range of non-tax-paying businesses becoming unviable as their limited margins are crimped by tax payment.
The informal sector accounts for more than 40 per cent of India's GDP and provides employment to close to 80 per cent of the labour force. Whilst it is difficult to capture details regarding the profit margins of the businesses in the informal sector, we assume that from Q3FY17 to Q4FY19, the share of the informal economy in India will shrink from 40 per cent to 20 per cent. Furthermore, the real-estate sector accounts for 11 per cent of India's GDP (source: 'White Paper on Black Money', Ministry of Finance). It will be fair to assume that this sector, which has been growing at an average pace of 11 per cent in real terms over the past five years, will now grow at a structurally lower pace.
Effect 3: The structural boost to tax-paying businesses in the formal sector
As the informal sector shrinks on the back of a crackdown in the black economy and on the back of GST implementation, the formal or organised sector is likely to gain market share as a 'formalisation effect' comes into play from the next year onwards.
The formal sector accounts for 60 per cent of India's GDP today. We assume that from Q3FY17 to Q4FY19, the share of the formal economy in India will expand from 60 per cent to 80 per cent. Besides the advances in market share that the formal sector will benefit from, incumbents are also likely to benefit from the reduction in the cost of debt capital that materialises as the quantum of white savings grows. Our analysis suggests that the cost of debt capital in India (proxied by the SBI lending rate) is likely to fall by about 360 bps by FY20 as savings move away from physical assets to the formal financial system.
Short-term pain for long-term gain
The further we move away from the announcement of November 8, the more moderated the adverse impacts on India's GDP growth will be. Whilst Ambit's economists expect GDP growth in H2FY17 to be 0.5 per cent (down from 6.4 per cent as per Ambit estimates in H1FY17), they also expect GDP growth to recover to 5.8 per cent in FY18 as the combination of rate cuts from the RBI and a fiscal stimulus from the government bears fruit. Then from FY19 onwards, we should see the true structural benefits of lower cost of capital and lower cost of real estate bear fruit.
Saurabh Mukherjea is CEO - Institutional Equities at Ambit Capital and the author of The Unusual Billionaires and Gurus of Chaos.
This article was originally published on February 02, 2017.
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