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Modi Trumps! - Outside View by Arvind Chari

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Modi Trumps!
Nov 11, 2016

In yet another bold move, this time economic, the Narendra Modi government has decided to demonetize the existing high value currency notes of Rs 500, and Rs 1,000.

The primary aim of course is to reduce black money (un accounted, un taxed income) but it will also help the government fight the menace of fake currency and terror funding.

Modi, won in 2014, promising to fight corruption and end the menace of black money. There is an overwhelming acceptance that corruption at the top-levels in the government and India Inc has fallen quite drastically since the new government took over. The press release issued on November 8th also highlights the other significant steps taken by the government to curb black money, 'including setting up of a Special Investigation Team (SIT); enacting a law regarding undisclosed foreign income and assets; amending the Double Taxation Avoidance Agreement between India and Mauritius and India and Cyprus; reaching an understanding with Switzerland for getting information on Bank accounts held by Indians with HSBC; encouraging the use of non-cash and digital payments; amending the Benami Transactions Act; and implementing the Income Declaration Scheme 2016"

We felt the disclosure under the Income Declaration Scheme (IDS-2016) of approx USD 10 bn was way below the overall unaccounted money in the system and must have disappointed the government.

Thus the government has now stepped up the pressure by de-monetizing the high denomination currency notes.

India's total currency in circulation is around USD 250 bn (~12% of GDP) and 85% of that (USD 210bn) is accounted by notes of Rs 500 and Rs 1,000. It is a no-brainer that the black money is held in high denomination notes.

Citizens will now have to deposit the old demonetized 500 and 1000 rupee notes into their bank account (with KYC) and get a part of the deposit exchanged for new currency and the rest will reflect in their bank account.

Needless to say, the income tax authorities will be tracking the deposits and large deposits not commensurate to the income filings will be investigated. The tax authorities have already said that penalty upto 200% of the unaccounted income will be levied.

This has large implications for the banking system and the bond market.

  1. Genuine cash of high denomination lying with citizens will get deposited but there are curbs on withdrawal for the time being - which will lead to massive net inflow into bank deposits. In the absence of credit demand, banks may find government bonds attractive to deploy the new liquidity. (my assumption: 40% of USD 210 bn= 85 bn$)
  2. Unaccounted money outside of the system will find its way into the banking system through various channels including by paying the taxes - leading to liquidity and fiscal boost (my assumption: 35% of USD 210 bn = 75bn$)
  3. Worried about the penalty and tax scrutiny, many might just take up the loss and not turn up the demonetized currency (ofcourse my assumption: 25% of USD 210 bn = 50bn$)

The third is the most significant from the governments perspective. The existing currency in circulation is the RBI's liability. If by the due-date of conversion (31 March 2017- this is likely to get extended), assuming 25% of this demonetized money is not deposited in the bank accounts, the RBI can write off that liability as the currency is no longer legal tender. That is a net gain of USD 50 bn to the RBI, which will show up as revaluation reserves on it's balance sheet. Logically, this increase in reserves should be used to cancel the government bonds that RBI holds in its balance sheet. This will reduce the government debt/GDP.

Can the RBI transfer that surplus as dividend to the government? I am not sure about it. If it can, it is a net fiscal gain of USD 50 bn for the government. Although, it should also result in the sale of assets from RBI.

India's fiscal deficit for Fy 17 is ~USD 80 bn. So, this is a significant amount of fiscal boost for the government, which it may use to spend on infrastructure, re-capitalise banks, write-down debt.

The actual outcome of course depends on how those assumptions pan out. We will track it closely. But it does suggest fall in bond yields, drop in lending rates and maybe even rate cuts by the RBI.

The bond markets have clearly rejoiced this move by the government with bond yields having fallen by 10-15 bps across the curve with some mild steepening.

Any of those 3 scenarios is a positive for the bond market (liquidity boost, tax increase or liability write off) and the tightness in the cash economy due to the outflow of high denomination should also compress demand growth and hence may even be dis-inflationary in the short term.

No wonder, India bond yields and the currency has ignored the rise in developed market bond yields on the back of the unprecedented Trump victory.

A Trump victory, we anticipated, will lead to faster rate hikes by FED and a rise in US treasury yields on the increased infrastructure spending with tax cuts promised by Trump in its election campaign. Under normal circumstances, that would have resulted in delayed rate cuts in India and a mild reversal in Indian bond yields upwards.

For now, Modi seems to have 'trumped' Trump on that.

Arvind Chari is Head Fixed Income & Alternatives at Quantum Advisors Pvt Ltd and advises two India dedicated off-shore India fixed income funds. Arvind was previously the fund manager for the Quantum Liquid Fund and the Quantum Equity Fund of Funds at Quantum Asset Management Company Pvt Ltd.


The views expressed in the Article are the personal views of the author, Arvind Chari and not views of Quantum Advisors Private Limited (QAS). QAS may or may not have the same view and does not endorse this view. The views expressed here in this article are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument. Information sourced from third parties cannot be guaranteed or was not independently verified. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date.

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2 Responses to "Modi Trumps!"

Sanjiv Gupta

Nov 19, 2016

While the intent is good the execution is poor. Modi is out Hit-Wicket batting @95 score. Rural economy my collapse badly and consumption theme may disappear. NPAs may shoot up. Scheme highly regretted by rural and farmers.
95% Black money is stashed in Property or Gold or shipped abroad.
He should have taken strong steps to stop generation of black money first. Government spending and Tendering is still riddled with commissions. Bribes are openly demanded and paid. No tangible ease of doing business.
It's Hit-Wicket



Nov 12, 2016

Most of the corrupt people had tons of money stored for many years. This has dramatically decreased the velocity of money. Hopefully, GDP will not be affected much because increase in velocity of money will compensate for decrease in money supply. As per you article M1 will be reduced by 25%. Time will tell.

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