The Impact Of Demonetisation & The US Elections On Indian Economy

While the world is still coming to terms with the results of the US presidential elections, back home, the government's "Demonetization" move caught everyone unprepared. The choice of timing of the move have kept many guessing what it would mean for the different asset classes.

1. Demonetisation
The transformational decision of Demonetization by the Indian government is intended at minimizing the black money and corruption and also attempts to plough these funds back into the system to be utilized to fuel the economic growth of India. To quantify the move, the outstanding amount under the currency notes of 500 and 1000 denominations is in excess of INR 14,00,000 crores, which amounts to more than 80% of the outstanding currency in circulation. This puts into perspective the intensity of the impact, not only in the debt & equity markets but also in larger sectors of the economy and interest rates. These can be summarized under following heads:

a. Trigger Deflationary Environment:
The move is expected to be deflationary in nature as the money in circulation will see a major reduction in the short term. The direct impact may be seen in discretionary spends, gold and real estate demand.

b. Reduction in interest rates:
Increase in the banks' deposit base would enhance the banking sector liquidity. A deflationary environment coupled with high liquidity and slow growth environment would improve the scope for further rate reductions. However, the stress levels in the financial sector notably the small & mid corporate sector could witness an uptick due to longer working capital cycles and raises fresh concerns over banking asset quality.

c. Buoyant government revenues:
The direct impact of the move is on government finances. We believe that there will be significant reduction of tax leakages owing to integration of black economy with the regular economy. Further, increased transparency and compliance will bring more people and organizations under tax net.

d. GDP Growth:
In the short term, consumption and investment demand are likely to take a beating owing to the cash crunch. Also, not all black money is going to flow back into the system and hence cash based transactions may witness a dent. Real estate and allied sectors may see near term to medium term negative impact. It may also lead to corporate earnings getting impacted in Q3FY17, as a large part of the old currency gets extinguished and takes time for fresh money to come into circulation. In the longer run, as the system gets aligned, growth is likely to come back to normal with higher government spending and possibility of lower inflation will lead to higher disposable income for individuals.

2. Trump Triumph
Going against most of opinion polls in the US, Republican presidential candidate Mr. Donald Trump secured victory as the 45th US President, in one of the most shocking political outcomes in the recent past. The announcement sent shockwaves and panic was witnessed across the bond and equities markets. However, apart from a few post-election jitters, the US markets soared highlighting the fact that the pro-growth policies promised by Mr. Trump are expected to propel economic growth and stocks. In India, the Trump effect was too trivial to do much damage as our PM (Prime Minister) offered more food to chew than markets could digest in the form of the Demonetization scheme. Nevertheless, to analyze the impact in isolation, it comes as a surprise positive to largely neutral in some sense.

a. US interest rates: Trump may adopt dovish approach
The most important factor for the world markets and India is the new government's stance on the interest rates in the US. While the December rate hike by the US Fed is largely factored in, most market participants opine that the Trump government may favor a more dovish monetary policy. This is in line with his pro-business policies such as substantial investments in infrastructure and boosting the spending power by cutting personal as well as corporate taxes. A Dovish US policy would lower the volatility on a global level and provide RBI with the impetus to lower the domestic lending rates.

" While the BPO & IT may suffer, a change in global equation could drive growth in other industries
Trump had indicated about restricting the entry of skilled foreign labor into the US in order to safeguard domestic workforce which could create some medium term issues for the Indian IT and BPO industry. But on a positive note, based on Trump's initial statements, US international policy may undergo a change and certain global equations could benefit India. For example, he may adopt a more conciliatory approach towards Russia; also change in stance of the US vis-à-vis Pakistan. In addition, Trump has also portrayed more affinity towards India compared to China. This may positively impact Indian export oriented industries which could be preferred compared to Chinese products.

3. Impact on debt markets
An expected surge in bank deposits will fuel the deflationary outlook and short term negative impact of demonetization on GDP, which may prompt the RBI for more and aggressive monetary accommodation in the near term. In addition, as suggested earlier, Trump's victory in the west may trigger a dovish monetary policy and provide further scope to the RBI to conduct its monetary policy action. Accordingly, a flush banking system with limited credit growth aided by monetary accommodation may lead to banks chasing bonds and thereby a rally in bonds and G-secs looks a very likely outcome.

4. Impact on equity markets
Although the impact of the US election outcome is projected to be limited, the domestic equity markets are expected to maintain a cautious approach in the near term until the demonetization's trickle down impact to the broader sectors of the economy is clear. Equity markets are expected to witness high volatility with a negative bias as the cash crunch is likely to hit multiple sectors. The sectors which are likely to be impacted are the Real Estate & Jewellery sector. Further, the financial sector, notably MFIs and NBFCs may witness a negative impact as their cash collections may witness meaningful disruptions and may add to asset quality pressures. Banking segment may witness negativity owing to concerns over SMEs and LAP loans. Effects may also be seen in cement, FMCG, metals, consumer durables and building materials companies on reduced demand in near term. Nevertheless, we remain optimistic about the strong fundamentals of the Indian economy in the medium-to-long term driven by the government's efforts to boost investment and demand through public spending, push to ensure higher disposable income by way of tax rationalization measures and monetary policy accommodation.

In conclusion, Demonetisation, if effective can be one of the most aggressive and decisive reforms taken by the current government. Though in the shorter term, there could be significant downtick in economic activity. However, a potential reduction in cash holdings would also point to lower currency 'leakage' from the banking system. Clubbed with GST, this move will have far reaching impact in merging the parallel and mainstream economy thus giving a further boost to India's GDP in long run & Improving the overall inflation outlook.