While the world was watching the outcome of the US Presidential election, a momentous policy change was announced in India. On November 8th, the Modi government announced that all 500 and 1,000 rupee notes would no longer be legal tender. Existing notes must be exchanged at a bank for new rupee notes and this must be done by December 31, 2016. These notes account for over 85% of total bills in circulation in India. The process of over a billion people changing this magnitude of old money into new money is a massive undertaking. We were on the ground in India a few days after the demonetisation was announced. We witnessed long lines at banks as people clambered to exchange notes.
The process is exacerbated by government imposed limits on how much new currency customers can withdraw at one time (less than AUD 500) and the fact that the new notes are not yet ATM compatible. Economic activity in the informal, cash-based economy has crashed to a halt, and consumption spending on anything other than basic necessities has slowed dramatically. In addition to site visits to banks, retail outlets and car dealerships, we attended a conference in Delhi to get senior managements’ view on how demonetisation would impact their businesses and the broader economy.
In sum, there is no visibility on the timeframe over which this will disrupt the economy, with views ranging anywhere from 2 weeks to 2-3 quarters. One thing is clear, however, December quarter results in India are going to be chaotic with top line growth very weak for all domestic-oriented sectors and significant changes in working capital as inventories pile up, and cash payables and receivables get stuck in the system. Longer term, however, demonetisation is a positive both for India as a country and for the Modi administration.
First of all, it cleans up the black economy as old note deposits of over 250,000 rupees (AUD 5,000) will be checked against income tax records and fines levied for people who have been evading taxes via the cash economy.
Secondly, it has resulted in a huge inflow of low-cost deposits into banks as money has come out from under the proverbial mattress to be exchanged for the new currency.
Thirdly, this move will generate significant fiscal benefits as it pushes the black economic activity into the taxable economy. It is expected that this fiscal benefit will be used to recapitalise public sector banks which could in turn kick start a much-needed investment cycle in India.
The final point is that Prime Minister Modi’s timing is impeccable. Cleaning up the black economy now will make the rollout of the GST in April 2017 much easier since the cash based portion of the economy has already been reduced. The fiscal benefit generated by demonetisation will facilitate financial sector reform and positive investment cycle dynamics. The benefits of these will begin to be seen by late 2018, early 2019, just in time for Modi’s re-election campaign.
In sum, demonetisation in India is short term pain for long-term gain. We have significantly reduced our country exposure in the short term based on a very weak 3Q results outlook and the fact that many of our holdings were consumer discretionary stocks and stocks with cash based working capital (cement). However, our long-term bullish view on India remains unchanged, possibly even strengthened, as a result of demonetisation.
Mary is the Portfolio Manager of Ellerston Asian Investments (ASX: EAI). She started her career as an investment banker with Citigroup in New York, London and Moscow, has a PhD in Economics from the University of Sydney, and an MBA from Harvard
Excellent insight! - great piece of research, something overlooked by the so called South Asian experts.