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Demonetization – Rebooting the Indian Financial System

Nov 15, 2016(19:26)
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Demonetization is arguably the boldest decision ever taken by the Government of India to curb the black money and reboot the entire financial system. It is very powerful in the sense that it completely transforms the way people of India deal with cash, accounting and paying taxes while using their money.

As part of the Demonetization process, Prime Minister Narendra Modi on November 8, 2016 had announced the decision to cancel the old higher denomination notes of Rs 500 and Rs 1000 in circulation and issue new notes of Rs 2000 and Rs 500. It also aims to address the unaccounted money problem, besides corruption and funding for terrorism (through fake currency notes).

Demonetization, in combination with Aadhar number linking with Jan-Dhan Yojna as well as other bank accounts, could be a decisive move towards digital money economy, which can have significant benefits for the country in the long term. It would far outweigh any inconvenience in the short term due to the logistical issues during the mammoth process of replacing 86% of the value of the money in circulation. 

The measure would firmly discourage the high-value cash transactions and push the high-value economic activities towards non-cash payment avenues like cheque/card/electronic transfer, which would significantly reduce the tax leakages in the entire system. This measure would improve the liquidity in the overall system and could lead to lower interest rates in the long term. The measures could discourage to a great extent the habit of hoarding physical cash which could be unproductive, unsafe and may be a fodder for anti-social activities in the black and grey markets. 

Finance Minister Arun Jaitley’s statement ‘dealing in unaccounted money is a not a fundamental right of any citizen’ truly reflects the government’s intent to expand the taxpayer base barring the people earning below Rs 2,50,000 per annum. This could add millions of individuals and enterprises in the unorganized sector who are currently dealing only in cash into the tax net, thus contributing to higher GDP growth. Based on the prospects of higher tax revenues from enlarged pool of taxpayers, government may be in a better position to consider lowering the tax rates. With higher tax revenues, government can kick start investments in infrastructure development, employment generation, welfare measures for the needy people and modernizing the armed forces to deter the hostile neighbors. Demonetization and pushing the economic activities towards the digital money improves the compliance and transparency of the entire financial system regarding accounting & taxation, which could automatically lower the incidence of corruption in these areas. This has the potential to improve India’s ranking in the ease of doing business and make the country a preferred investment destination for the global investors in the long term.

Overall, demonetization and transition towards digital money would help India to reboot the entire financial system for a brighter future. It can be the foundation, and on top of that, more measures like curbing ‘the benami transactions, illegal gold purchases, illegal transactions in grey market’ and talks of making the financial year from January to December could create volatility in the short term but will ultimately improve the efficiency of the financial markets in the long term.

All these measures are expected to result in higher tax revenues, improved fiscal condition, higher GDP growth, lower interest rates which augurs well for the Indian equity markets in the long term.

However, as a major portion of Indian financial system is traditionally used to dealing in physical cash and transition is going to take a little more time due to the initial natural resistance for the big change. Taking cues from the successful implementation of Aadhaar and Jan Dhan Yojana, even Demonetization is also going to deliver the intended results in the medium to long term.

Amid the transition, Indian Equity markets has witnessed sell-off in the short term due to shortage of cash which has led to slow down in consumer focused business like the Automobiles, Consumer Goods, Jewellery, Real-estate, Cement, NBFC and Textiles. On the global front, US President-Elect Donald Trump’s stated policies on Infrastructure spending has led to spike in Bond yields and correction in emerging market equities.

Overall, the short term knee-jerk reaction to demonetization in India, coupled with emerging markets response to Trump’s Victory in the US, provides an attractive entry opportunity in the Indian Equity Markets for long term investors. Amid vibrant prospects in the long term, investors should select good quality stocks from Automobiles, BFSI, Cement, Consumer goods, Infrastructure, Metals and Oil & Gas sectors and invest in a systematic manner to realize the potential benefits of Indian Equities.

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