DEMONETISATION: Panacea for Vulnerabilities in the Indian Financial System

In an earlier blog post, I had argued that demonetisation is by far the boldest and, perhaps, the best decision that government has taken since independence, notwithstanding the sloppy, if not negligent, execution. The economic benefits of the scheme are far-reaching in the medium- to long-term, both from the fiscal and monetary policy perspectives.

What many detractors of the move fail to realise is that demonetisation, and its tightly-coupled Siamese twin of “Cashless (or, Less-Cash) Economy”, have far-reaching implications on the robustness of our banking and financial systems too. It eliminates, or, in the least mitigates, the serious risk of vulnerabilities within our financial system being exploited by hostile nations.

Let me expound the details of why I believe the Indian financial system has been made more immune to inimical forces, courtesy demonetisation.

Economics of Rise in Property Values

To begin with, the high “currency in circulation” had created a vibrant parallel economy driven by the troika of graft, tax evasion and money laundering. In the result, real property prices have gone through the roof artificially, courtesy, sizeable hoarding of black money and its conversion through investments on benami holdings of property. Other sectors too─ for example, retail, hospitality and entertainment─ have served as vehicles for transforming crime and corruption money into legitimate assets and properties.

The “wealth effect” of the spiraling land and home prices further brings into play positive consumer sentiment, not to mention higher levels of consumer spend─ the consumption is often driven by ‘Keep up with the Jones' Effect’. The demand puts pressure on price indices and frequently also drives up consumer debt. The burgeoning property prices drive long-term capital gains (on resale of property), which further augments GDP growth and per capita income─ a mirage of sorts.

The buoyant consumer sentiment invariably triggers bullishness in the secondary markets. In such a scenario, retail investors tend to take undue risks driven totally by intuition and technical analyses rather than sound fundamentals of scrips.

Impact of the Parallel Economy

Further, as is well known, a thriving parallel “cash-based” economy not only hurts direct and indirect tax collections of government, but also leads to higher fiscal deficits. The tax evasion indeed spikes discretionary incomes and propensity to spend of households. Markets become price insensitive and demand inelastic. Thus, excess cash in the economy exerts inflationary pressures on the economy. Besides, it also drives up the demand for luxury products and imported (premium) goods (specifically, Giffen and Veblen goods). This increases current account deficit (CAD), which weakens the Rupee in currency markets.

The obvious result: The dreaded monster called “inflation”. And as a ripple effect: higher interest rates, which dampen domestic investment, thus slowing down the economy.

But, there is another not-so-obvious effect of excess cash, namely, “jobless growth”.

Currency-in-Circulation Levels

Several unique peculiarities exist in the Indian economy, including, but not limited to: (a) a young workforce; (b) 85% of the workforce employed in the informal sector; (c) large rural and agrarian demographic profile; (d) high levels of graft and corruption; (e) lack of transparency in governance; (f) bureaucratic apathy and inefficiencies; (g) judicial logjams; (h) ever widening “rich-poor gap”; (i) low base of only about 1.25 crore individual tax-payers; and, so on.

These characteristics are also manifest in the excessive currency hoarding and massive money laundering. RBI data clearly shows that “Currency in Circulation (CIC)” has risen exponentially [refer Graph-1 below] and totally disproportionate to the size of our economy and its needs.

CHART-1

The table above also shows that CIC rose alarmingly by 15% year-on-year to almost INR 16.65 lakh crores as on 31-3-2016. That means INR 2.2 lakh crores, that is, INR 2.2 trillion, was added to CIC in the year 2015-16. This is clearly reflective of the many systemic lacunae within our monetary system. Surely such insatiable appetite for currency notes is completely unsustainable in the long haul for any economy.

The demonetisation decision, aimed primarily at unearthing and eliminating black money, has a desirable side-effect, intended or otherwise. It has sucked out excess currency from the monetary system. This not only tames inflation, but also provides for a more balanced growth driven by domestic investment and development of infrastructure.

Ultimate Barometer of the Economy

Any economist or finance professional worth his salt will readily confirm that the final litmus test for economic outlook of a country is its capital market. The collective wisdom and sentiment of investors in the secondary market serves as a barometer for future economic prospects. This can be clearly witnessed in the BSE Sensex movement since the 1980s [refer Chart-2 below].

 CHART--2

Whenever a significant financial crisis has hit the country, the BSE Index has lost significantly. For instance, during the 60-day period immediately following the breakout of the “Big Bull (Harshad Mehta) Scam”, the BSE had dropped from 3,900 to 3,080 points, thereby loosing over 21% of its market capitalisation.

Market Reaction to Demonetisation

In comparison, from stock market trading trends and BSE Sensex movement (refer Chart-3 below), it is apparent that demonetisation has had minimal impact on investor sentiment. In fact, on Nov.9, 2016, the day following Prime Minister Narendra Modi’s announcement the bourse reacted positively. The index did loose some points and the markets were jittery post-demonetisation during November and December 2016. However, the markets have managed to recover all losses and as on Jan.9, 2017, BSE Sensex is marginally ahead vis-à-vis its value on Nov.8, 2016. 

CHART-3

Foreign Institutional Investor (FII) Activity

Of course, the remarkable thing about the post-demonetisation performance of the exchanges is that it has weathered the storm of FII’s collectively pulling out about US$20 billion out from their Assets under Custody (AUC) in all of November2016. So, the net fall in the value of FII investments post Nov.8, 2016 can be estimated at about US$14 billion. The data on the (notional) values of Overseas Derivative Instruments (ODIs) with FIIs for December 2016 has not been released by SEBI as on date.  

The net outflow of FII funds in November 2016 seems to have been driven by the impressive rally of the US$ against all other major currencies. This is a phenomenon that occurs every time the American Dollar strengthens in forex markets. The fact that FIIs are still invested in India to the tune of about US$300 billion is an indication of their intrinsic faith in the India growth story, notwithstanding the high levels of toxic, non-performing assets of Indian banks.

Vulnerabilities in the Financial System of India

Historical analysis of market performance shows that the participation of FIIs in trading on the Indian bourse has resulted in the tight integration of our economy with the global financial system. Market performance of BSE has mirrored the activity of FIIs (refer Chart-4 below) so closely that the time series plot of FII Assets under Custody (AUC) looks like a shadow of the BSE Index graph.

CHART-4

While such integration is welcome, it must be crucially noted that our economy is susceptible to a collapse, in the event of a bear-run (for any reason whatsoever) launched by FIIs. The ODI investments through the Participatory Notes (P-notes) route only exacerbates this risk, because of the anonymity afforded to overseas investors in P-notes.

Hypothetical Scenario
To drive home my point, I elaborate with a hypothetical scenario. Let us say, a hostile country in the region, for geo-political reasons, wants to impede, perhaps even derail the Indian economy. Suppose it sets up an offshore fund of, say, US$ 50 or 100 billion, and uses the entire amount to build its position in P-notes slowly and surreptitiously over several weeks. Those funds entering the system will surely buoy the markets, which will go on a bull run, which will definitely also drive the value of the fund’s investment by 2X or 3X.

So then, in such a scenario, the stress on the secondary markets would be enormous, if, at an opportune time when the market is at a peak, the enemy country were to suddenly pull out its entire investment in P-notes. Panic would set in and nose-diving stock prices would drive the market to abysmally low levels (despite circuit breakers being applied on trading each day). The bear market would: inflict serious losses on investors; impinge upon investor and consumer sentiments; erode corporate earnings; lead to job cuts; devalue the Rupee significantly and, curtail household expenditure. In other words, the India’s economy would head towards a recession and perhaps even a depression. 
It would surely take a long time for the country to recover from such a catastrophe.

Conclusions

The additional deposits mobilized by banks through demonetisation, if judiciously used, can be used to supply liquidity in both currency and stock markets. Margin pressure can be eased and recall risk can be averted by providing adequate credit covers in such emergent, apocalyptic scenarios. The "Money Multiplier" effect under the "Fractional Reserve" banking system would be the icing on the cake.
Indeed, the benefits of demonetisation are willy-nilly so far-reaching that the structural framework of the Indian financial system will become robust and resilient.

On top, the aggressive push toward a “Cashless/Less-Cash Economy” will further strengthen the economy and render it more immune to financial artifice, even while insulating it from economic shocks in the rest of the world. 
It perhaps makes sense for government to not only reduce its fiscal deficits, but also use the additional resources generated to create a sovereign fund for use as a stabilizer through market interventions in stock exchanges. Of course, a number of rough edges will have to be smoothed out before government can launch such an initiative.

All in all, demonetisation is a win-win for the country! Isn’t it?
The information released by the Income Tax Department do seem to indicate so. The markets too seem to have given "two-thumbs-up" to the move.