Earlier this month, the government took a bold move by opting for demonetization. This step was taken to fight against corruption, black money, money laundering, financing of terrorism and counterfeit notes. This move directly targets the shadow (parallel) economy which, according to various estimates, is as large as 20%-25% of India’s GDP. Also, the unaccounted cash in circulation has a direct effect on inflation, which hurts the purchasing power of the common man.
Dhaval Kapadia, CFA, Director - Portfolio Specialist, and Chintan Mehta, CFA, Senior Investment Analyst, of Morningstar Investment Adviser India, discuss the impact it has on the economy.
What’s the short- to medium-term impact on the economy?
In the short term this may have a negative impact on consumption, as the old notes are either deposited with banks or converted into new currency and unaccounted wealth becomes static.
Slowdown in real estate and related sectors which are driven by the cash economy could impact the GDP growth rate in the near term.
On the other hand, the recent payouts from the Seventh Pay Commission could buffer consumption.
Also, based on various media reports, if a portion (some estimates put it at ₹1.50-2 lakh crores) of the cash in circulation doesn’t come back to the banking system, it would allow the Reserve Bank of India, or RBI, to transfer the additional reserves to the government which can be used for infrastructure spending, bank re-capitalization, etc. This could potentially buffer GDP growth, albeit over the medium term.
As consumption reduces in the near term, inflationary pressures could reduce, thereby providing space to the RBI to cut rates.
And over the long term?
Over the long term, the positive impact of this measure is manifold.
First, inflation could come down further as the unaccounted cash in the economy will be sucked out which would improve the purchasing power.
Second, Indians put a big portion of their household savings in the form of physical savings, such as gold and real estate, instead of financial savings. This may change over the long term as households reduce their allocation towards physical assets as these become unattractive.
Third, the size of GDP may increase with the curb on the shadow (parallel) economy, as more transactions will be accounted in the formal economy. Fourth, India’s trade deficit may narrow further with a sharp drop in gold imports.
Lastly, increase in tax compliance and collections should help the government in improving its fiscal situation.
Which sectors are most affected by this move?
In the short term, the announcement could negatively impact sectors like real estate, NBFCs, banks and auto. Removal of black money may lead to a fall in real estate prices as the sector is known for dealing in cash transactions of large magnitude. Demand for vehicles and luxury items may remain subdued in the interim with reduced money supply and limited amount of money in circulation.
NBFCs and banks may face short term challenges in loan recovery from small and medium enterprises (SMEs) and other segments. However, banking sector may get a big boost over the long term as the bank deposits will increase with black money being channelized into the formal economy.
Did the announcement catch Morningstar’s Model Portfolios off guard?
Our model portfolios are driven by long-term valuation-driven investing and the investment process would continue as is. Events like this may induce bouts of volatility on the portfolios; however, one must be mindful of the fact that these portfolios are designed to be part of an investor’s long term investing plan.
What should investors do?
Remain calm!
Investors should continue to stick to their long-term investment plan and increase allocation to financial assets vis-a-vis physical assets. Fall in markets due to such events might provide attractive investment opportunities.
Also Read: The impact of demonetization on residential real estate
