Prime Minister Narendra Modi on the 8th of November, 2016, announced the withdrawal of Rs 500 and Rs 1,000 denomination of notes. He called this step necessary in the government’s fight against corruption and black money. The legal tender character of the abovementioned denomination of bank notes stood withdrawn. Thereafter, these notes could not be used for transacting or storing for future use. What were the effects of demonetization on mutual funds and other industries? Let’s find out.

History of Demonetization in India

India has a long-standing relationship with demonetization.

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  1. First currency ban: In 1946, the currency note of Rs 1,000 and Rs 10,000 were removed from circulation. The high denomination of currency was only assessable to a few people in the society, thereby implying that demonetization was not a big success.
  2. Second currency ban: In 1978; the then Prime Minister of India Morarji Desai announced the currency ban taking Rs 1000, Rs 5000 and Rs 10,000 out of circulation. Like the demonetization in 2016, the aim of this demonetization was also curbing black money.

Effects of Demonetization on Mutual Funds

Overall, the demonetization impact on mutual funds growth is expected to stay for 1-2 years. Beyond that, it’s expected that there shall be a transition from the unorganized to the organized sector. Therefore, long-term investment decisions are not advised to be biased by such events. In short term, some volatility can still play out as the results of the event unfold.

Effect of Demonetization on Debt Funds

They are an investment class wherein the funds are invested in fixed income-generating assets such as debt or money market instruments.

With people depositing demonetized notes into their bank accounts, RBI witnessed that close to Rs. 15.28 trillion came back into the system. RBI responded to the excess liquidity that it had moped up by reducing interest rates. However, in spite of this effort, RBI would have to resort to buying bonds which would improve the returns under debt funds in the short term, until this situation is normalized. However, in the long run, a permanent reduction in the interest rates may lead to a negative impact on the Debt fund returns.

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Effect of Demonetization on Equity Funds

Impacted because of the liquidity crisis and fearful sentiments, equity funds were negatively impacted in the short term, before recovering after a few months. Some of the worst affected sectors were real estate and consumer durables which depend on cash for their business. However, it is expected that the shift from unorganized to organized sector, which demonetization will bring in its course, in the long run, shall prove to be positive overall for the equity funds.

Among equity funds, large-cap funds by virtue of being more stable have shown lower price fluctuation and volatility as compared to small and micro-cap fund, which have shown greater price fluctuation and volatility.

Demonetization led to stock market index Nifty 50, crashing by around 500 points from 8400 levels to a low of around 7900 levels. Similarly, benchmark index Sensex fell from 27500 levels to a low of 25800 levels within a short span of one month.

Cumulatively demonetization along with GST and other global and domestic factors culminated to India posting a low GDP growth rate figure of 5.7% in Q1 of FY 2017-18. This was quite a dip as compared to the GDP growth rate of 7.9% for the same quarter a year earlier. Manufacturing bore the brunt of this reform step, falling to a low of 1.2% growth as compared to 10.7% a year ago, for the same quarter. Although it would not be correct to attribute demonetization as the sole villain for the dip in the GDP, but it was definitely one of the most important ones. There was a general fall in business activity in the one month after demonetization with most businesses operating out of a high requirement for cash.

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Demonetization and the Indian Economy

demonetization effects mutual funds

The movement of Indian stock market during and after demonetization should not be analyzed in silos. The stock market is affected by the interplay of a variety of factors (global and domestic). Key global issues such as US Presidential Elections, oil prices and currency fluctuations among others also contribute to the rise and fall of the Indian stock market index.

Impact of Demonetization on Real Estate

Since Real Estate is driven by the black economy and cash transactions, this was the sector that was probably the worst hit of all the sectors. The Nifty Realty index gapped down after the day of the demonetization move and corrected -25%.

Impact of Demonetization on Banking

The Banking sector took an immediate hit the day after the announcement but recovered on Nov 10th. But, it has been subsequently correcting as it is still grappling with trying to replenish the cash in the economy. However, this is one sector which is expected to benefit in the long term because a lot of the black money will be deposited in bank accounts and the excess funds in the banking system will also help address the non-performing assets (NPA) problem that many of the banks are facing due to bad loans.

Impact of Demonetization on Infrastructure

The infrastructure sector is driven by massive capital investments by the government as well as loans taken from banks. Demonetization is expected to increase the liquidity in the banking system, which could persuade the government to entail its vision of building infrastructure in India through its vision of ‘Make in India’. Therefore, the Infrastructure should be an obvious beneficiary of that. The fact that the NIFTYINFRA index has not been affected much, as is confirmed by the fact that it is up marginally since Nov 8th.

Impact of Demonetization on Information Technology

Since this industry is mainly driven by exports to foreign countries, this industry is comparatively unaffected/ less affected by the event of Demonetization. Next, the IT sector is largely a cash-less or less-cash sector, therefore lesser impact.

Impact of Demonetization on Agriculture

Agriculture, which constitutes a majority of the primary sector, contributes about 15% to the country’s GDP and employees about 50% of the country’s population. Given the importance of this sector in our country, demonetization has had a critical impact on this sector.

Cash is the primary mode of transaction, in villages in general and agricultural sector in particular. With the ban of Rs 500 and 1000 denomination of notes, agriculture sector came under direct jeopardy with major reliance on cash, for day-to-day business activities. Moreover, Nov-Dec time of Kharif harvest and start of rabi sowing is often referred to as the ‘busy season’ from a standpoint of credit demand.

Sale, transport, marketing and distribution of ready produce to wholesale centers or mandis, is dominantly cash-dependent. Most of the businesses in this sector are operating at a sub-optimal level, with low cash liquidity being at the center of the problems.

Demonetization from the Who’s Who of the Industry

“PM has only wiped out confidence, not corruption”, Rahul Gandhi.

“The prime minister claimed his decision was aimed at wiping out corruption. Twelve months on the only thing he has wiped out is confidence in our once-booming economy,” – Rahul Gandhi.

Nobel laureate, Amartya Sen believes that Demonetization was an authoritarian move, and called it a failure. He disagrees with the governments claims as well.

Former PM and RBI governor, Dr. Manmohan Singh called the move an ‘organized loot’, a ‘legalized plunder’ and a ‘monumental mismanagement’. He also questioned the government by asking why people were not allowed to withdraw their own money. Further, he questioned that who was to make good the harm caused on the agriculture sector and the informal sector.

To this counter, current Finance minister, Mr. Arun Jaitley claimed that as a result of the demonetization move the government will be in a position to invest more money in the agriculture and social sector in the long run.

Prithviraj Chavan, Former Maharashtra Chief Minister, demanded a probe to ascertain the “real intention” behind demonetization, and in this process he said-

“As time passed after demonetization, a different scenario came up, contradicting the initial claims made by the prime minister on November 8 (last year), while announcing the exercise. This was an impulsive decision which hurt the country to no ends.”

Finance Minister says demonetization was “ethical”. Was it ethical to heap misery on millions of people, especially 15 crore daily wage earners? Said Mr. P. Chidambaram.

West Bengal Chief Minister Mamata Banerjee expressed that the demonetization exercise was a “DeMoDisaster”.  Moreover, she also changed her Twitter display picture to black colour, on the first anniversary of the event.

The stock price of major agriculture players took a hit as a result of the demonetization.

Kaveri seeds share price fell almost 10% from 405 levels to 360 levels in the one-month post demonetization. Similarly, the share price for Meghmani Organics, a major player in the pesticide business, also fell from 45 to 35 levels, a fall of around 20% in the month period.

World opinion on Demonetization

World Bank CEO Kristalina Georgieva on Thursday lauded PM Narendra Modi’s demonetization move. “PM Modi’s decision to ban high-value banknotes as part of efforts to stamp out corruption will have a profound and positive impact on India’s economy,” she told Hindustan Times. “What India has done will be studied (by other countries). There hasn’t been such demonetization in a country so big,”

The Chinese media– they offered its appreciation and advice on PM Modi’s advance on corruption. They have called it a “bold and decisive step”, but expressed that it is not enough. They believe that “delivering a corruption free country requires more than banning currency notes. The key should be reforming systems.” Having dealt with its own share of corruption, China urges India to work towards creating a transparent system.

Kuwait times – They mention in an article that the effect of the demonetization “has caught many Indian expatriates unawares in Kuwait as money changes refuse to accept the currency.” Kuwait is home to around 80,00,000 expatriates, and as per prevalent practices, the non-resident Indians (NRIs) stash away Rs 25,000 which is a legal entitlement to meet their immediate requirements when they travel in and out of the country.

The New York Times – “Cash is king in India. It is used in an estimated 78 per cent of transactions, compared with 20 per cent to 25 per cent in industrialized countries like Britain and the United States. Many people do not have bank accounts or credit cards, and even those who do often must use cash because many businesses don’t accept other forms of payment.”

Demonetization and RBI

demonetization mutual funds

For the Reserve Bank of India (RBI) at least, the note ban was one of the key reasons for lower profits. The government was also on the receiving end of the move, by way of lower dividend it received from the central bank. RBI paid only Rs30, 663 crore as dividend compared to Rs65, 880 crore a year ago.

RBI’s income for its financial year ending 30 June fell 23.56% to Rs61, 818 crore. Sharp drop in the Reserve Bank of India’s (RBI) dividend payout to the government primarily on account of the cost of printing currency and the cost of soaking up excess liquidity from the financial system.

Net income from domestic sources fell 17.11%. This was largely because RBI had to pay interest of Rs17,426 crore as it mopped up excess liquidity in the banking system after people rushed to deposit invalidated currency notes at banks. Contrast this with the year before, RBI received a positive Rs 506 crore out of the liquid funds management.

On the expenditure side, the central bank spent Rs7,965 crore on printing currency notes in 2016-17, more than double the Rs3,420 crore spent a year ago. In its effort to provide a fillip to the economy, the RBI aimed to quickly re-monetize the economy. Towards this aim, it issued 29 billion currency note pieces in 2016-17, against 21.2 billion in the previous year.

To summarize, RBI’s extra interest expenses of Rs17, 426 crore, the extra printing cost of Rs4, 545 crore and provision of Rs13, 100 crore together make up just about the Rs35, 217 crore decrease in net profit.

Need for demonetization? (As per government)

As per Economic Survey of India2016-17, our tax-to-GDP ratio is 16.6% well below the average of 25-30%. This implies we collect less tax compared to our size. This means Government revenues are insufficient to fund developmental projects, forcing us to borrow. Roughly, 5.5% of earning individuals pay taxes. It is very important to stop tax evasion, bring more people under the tax scanner and prevent black money generation. Demonetisation was aimed at doing exactly that.

Vision behind demonetization (As per government)

Demonetisation, as stated by the government, is one among a string of steps that the government has been taking to attack black money. First, it had given a three-month window for bringing back unaccounted money stashed in offshore accounts, but the response was not good. The next target was black money within India. The Income Disclosure Scheme 2016 has been relatively successful. The government also passed a law to curb Benami transactions and India’s Double Taxation Avoidance Agreements with Mauritius and Cyprus have been amended. The government suggested that the move of demonetization should not be viewed or judged in silos, as it is a part of the larger scheme of things laid out by the government to eradicate black money.

Government on Achievements of Demonetization

  1. There has been a rise in the use of debit and credit cards, particularly in the segment which probably never used cards before. Every such transaction leaves a trail behind and makes sure that more and more people will come into the tax net. We cannot ignore the benefits of digitalization of cash transactions and a definite move towards a less-cash economy.
  2. For 2016-17, 1.26 crore new taxpayer’s (return filers plus non-filers making tax payments) were added to the tax base (till June 30, 2017).
  3. The effect of demonetization is also clearly visible in the 19% growth in direct tax collections. Advance tax collections under personal income tax head revealed a growth of about 41.79% over 2016-2017. Collection of self-assessment tax under the head of personal income tax showed a growth of 34.25%.
  4. India’s CASH TO GDP number has gone from 13% to 7.3%, post demonetization. Eventually, it is expected to settle at 10%, which is expected to bring more transparency and accounting in the system. Taking India closer to the ‘Less-cash economy’ vision.
  5. It is true that 99% of the money has come back in the system, but close to 50% of the money has not moved out even after nine months, leading to an unprecedented close to 9200 basis points (one basis point is one-hundredth of a percentage point) increase in financial savings to GDP (gross domestic product) ratio and a significant reduction in interest rates.
  6. Demonetisation has improved transmission in the banking system and led to the greater financialization of savings. Look at the way the banks have reduced their loan rates in past nine months because they are flush with money. That could go a long way in bringing down the cost of investment when the borrowers decide to lift the bank money.
  7. Not surprisingly, the income tax department has issued a large number of notices asking questions about the source of income.

Criticism of Demonetization

Value of the currency that returned to the system at Rs 15.28 trillion or close to 99% of the currency notes demonetized in November-December 2016. The fact that more than 99% of the invalidated high-value notes came back to the banking system is widely used as evidence supporting the view that demonetization has failed to curb the Black money menace.

With the demonetization behind us, the markets are beginning to flourish again.

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Disclaimer: the views expressed here are those of the author. Mutual funds are subject to market risks. Please read the offer document before investing.