Demonetization Impact on Mutual Funds in India

On Nov 8, 2016, the Indian government declared that all the 500 and 1000 rs notes would cease to be legal tender from the next day. The bold step meant to remove the fake currency and clean up the black money.

It was a once-in-a-generation experience that will go down in history as one of the most meaningful economic events. It affected every Indian citizen. Demonetization impacted the economy via the liquidity side.

As the government removed roughly 86% of the money value in circulation without replacing most of it, its impact was substantial. As a result of the withdrawal of Rs 500 and Rs 1000 notes, there is a significant gap in the currency composition, with Rs 2000 being the only denomination after Rs 100.

Impact of Demonetization on the Indian Stock Exchange

The repercussions of demonetization on the Indian stock market were rapid and severe, with benchmark indices falling sharply in the days after the declaration.

The Bombay Stock Exchange's benchmark index, the BSE Sensex, plummeted by roughly 1,700 points or 6.4% in just four trading days, while the National Stock Exchange's benchmark index, the NSE Nifty, plummeted by approximately 550 points or 6.3%.

The stock market fell mainly due to the ambiguity induced by the announcement. Investors were uncertain about how demonetization will affect the Indian economy soon and was concerned about the possible impact on corporate profits.

However, the Indian stock market steadily rebounded over the next several weeks as the government implemented measures to reduce the fiscal impact of demonization.

For instance, the Reserve Bank of India (RBI) pumped more liquidity into the banking system to guarantee that the public had sufficient cash for transactions.

Furthermore, when people began transitioning beyond cash transactions, demonetization increased the demand for digital commerce and online banking services. As a result, firms' stock prices in the digital payments and banking industries surged. For example, in the months following the demonetization, the stock prices of firms such as Paytm, HDFC Bank, and ICICI Bank increased significantly.

Impact of Demonetization on Mutual Funds

The instantaneous result of demonetization was a rise in mutual fund inflows as investors sought alternate investing choices after the cash ban. However, the long-term impact was more complicated, with some funds outperforming others after demonetization.

• Inflows

In the early wake of the demonetization, there was a drop in inflows due to a paucity of cash in the financial system, as investors were preoccupied with exchanging or depositing their old currency notes in banks.

Nevertheless, this was a brief drop, and mutual fund inflows quickly recovered. Moreover, one of the influential post-demonetization developments was a shift in investor attitudes towards equity mutual funds since low-interest rates made equity investments more appealing to investors desiring higher returns.

Consequently, demonetization had a long-term beneficial impact on mutual fund inflows, with the sector enjoying record inflows in the years after demonetization.

• Equity Funds

Investors switched from traditional savings options such as fixed deposits as interest rates fell. As a result, it increased inflows into equity funds, with numerous investors discovering it as a superior investment alternative.

Equity funds had net inflows of over Rs. 1 lakh crore in FY 2017-18, a 73% boost over the year before. The pattern persisted in successive years, with equities funds accounting for most mutual fund inflows.

To meet investor demand, the robust inflows into equity funds led to an upsurge in new fund offerings (NFOs) and the establishment of various thematic and sectoral funds.

• Debt Funds

Demonetization also resulted in an upsurge in people depositing in banks, resulting in surplus liquidity in financial institutions.

This and the Reserve Bank of India's (RBI) liquidity tightening efforts resulted in decreased debt instrument yields, significantly hurting debt fund returns. As a result, investors began to transfer their assets away from debt funds and towards equity funds. 

• Small and Mid-Cap Funds

Due to the market's overall volatility post-demonetization, there was a decrease in inflows into small and mid-cap funds.

It was worsened by the liquidity crisis that hurt small and mid-cap enterprises, resulting in a drop in stock values. However, once the market calmed, inflows to small and mid-cap funds began to rebound. One cause was improved economic factors, resulting in a profit rebound for small and mid-cap enterprises.

Furthermore, the decrease in interest rates rendered equities more appealing to investors, which increased inflows into small and mid-cap funds. As a result, small and mid-cap funds beat the overall market in the years after the demonetization, with some funds outperforming the market by over 50% as a whole all together.

• Increased Adoption of Digital Channels

Demonetization has a significant influence on India's rising usage of digital channels.

With the unexpected demonetization of high-value currency notes, people were forced to rely on digital payment methods to conduct their daily activities. Consequently, the adoption of digital payment methods such as mobile wallets, UPI, and other digital payment choices have increased significantly. In addition, the government has implemented several measures to boost digital payments, like cashback and discounts on digital payments.

As a result, the increasing use of digital channels benefited the fintech industry, which experienced rapid expansion in the years after demonetization.

Furthermore, demonetization transformed consumer behaviour towards digital channels, with an increasing number of consumers choosing the ease and security of digital channels. This shift in consumer behaviour also resulted in more significant investments in digital infrastructure and technology, strengthening the country's digital ecosystem.

Conclusion

Demonetization had a mixed impact on the Indian stock exchange, with specific industries suffering short-term setbacks while others profited in the long run. However, it is vital to remember that the objective of demonetization was to reduce illegal money and promote a cashless economy rather than to stimulate the stock market.

Today, the country reached the pinnacle of its cashless economy. Hence, it can be assumed that demonetization has proven to be a timely gift.