The demonetisation-driven cash crunch that is playing out in India will create short-term economic pain in the form of the transactional hit created by a hard cash deficit and the structural hit to non-tax paying businesses that would become unviable.
As we move further away from this event, however, the Narendra Modi government’s larger crackdown on black money and its resolve to check tax evasion will yield two distinct sets of benefits: A lower cost of capital and higher flows into the financial services sector.
Also, as the informal sector shrinks on the back of a crackdown in the black economy and on the back of the GST implementation, the formal organised sector is likely to gain market share as a ‘formalisation effect’ comes into play from the next year onwards. This article describes in greater detail these complex set of effects that demonetisation will trigger in the short to long run.
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 suggests that 87 percent of all transactions in India in the financial year 2012-2013 (FY12) were executed in cash form and approximately 83 percent of all transactions in India are likely to have materialised in cash form in FY17.
To complicate matters further, Ambit Capital's calculations suggest that a cash deficit of Rs 8.5 trillion is likely to materialise in the third quarter of FY17, as the pace of cash disbursals does not keep pace with the overnight destruction in value of Rs 14 trillion.
Thus, in a cash-based economy where close to 83 percent of transactions materialise in the form of cash, a cash deficit to the tune of Rs 8.5 trillion or 5.7 percent of the GDP is expected to materialise in third quarter of FY17 and continue into the fourth quarter of FY17 (albeit to a lesser extent). This then, is bound to have a paralysing effect on economic activity levels in the short term.
The informal sector accounts for more than 40 percent of India’s GDP and provides employment to close to 80 percent of the labour force. While it is difficult to capture details regarding the profit margins of businesses in the informal sector, it is safe to assume that from the third quarter FY17 to fourth quarter FY19, the share of the informal economy in India could shrink from 40 percent to 20 percent. This shrinkage of the informal sector is likely to result in a short-term adverse effect as the informal sector is no longer able to employ the numbers that it did.
However, as the informal sector shrinks, the formal organised sector is likely to gain market share. The formal sector accounts for 60 percent of India’s GDP today. Ambit Capital assumes that from FY17 to fourth quarter FY19, the share of the formal economy in India could expand from 60 percent to 80 percent.
Furthermore, the sustained crackdown on black money will prevent people from parking their savings in physical assets such as gold and real estate. This should boost the flow of savings into the financial system to a significant extent. This in turn should spell a higher influx of flows for financial services providers such as banks, non-banking financial companies (NBFCs) and stockbrokers.
Most importantly, as the quantum of financial savings increases, the cost of debt capital in India should fall. Ambit Capital's analysis suggests that as the quantum of India’s savings increases by approximately 4 percent of GDP over FY17 to FY20, lending rates are likely to fall by approximately 350 basis points, assuming that investments as a percentage of GDP remain constant during this period.
Thus, while the ongoing changes are likely to engender painful side effects in the short term, the long term benefits of the Modi government’s crackdown on tax evasion and black money are undeniable.
Ritika Mankar-Mukherjee is senior economist and Saurabh Mukherjea is CEO (institutional equities) at Ambit Capital