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India is primarily a cash based economy. As per 2011 census, 31% people reside in urban and semi-urban areas where banking connectivity is weak. Further, India is second to Japan with cash to GDP of ~10.9%.
The demonetisation has shocked the economy to a grinding halt. The consumer sentiment is low due to lack of cash. There are concerns about the demand pickup.
There is a high cost associated with demonetisation. The costs may eat up the majority of expected benefit from unearthing of the unaccounted money.
There are talks about the impairment in India's growth trajectory for next two years. However, every estimate made on GDP is just a guess as It is impossible to estimate the exact impact.
We believe the impact on the GDP is highly exaggerated.
No doubt, we are witnessing short term hiccups. But there are some structural changes which will benefit India. The positives are way more than just curbing unaccounted money.
First, as we know any currency issued is a liability for Reserve Bank of India, which owes a particular value to its holder. So, any money not coming back to the banking system will reduce the RBIs liability to that extent.
The total outstanding value of the demonetised currency is expected to be around Rs 14.2 trillion as of 31st March 2016. Of this, Government expects Rs 4-5 trillion to be unaccounted cash.
This would improve the balance sheet of RBI and Government providing them some leeway to spend for the betterment of the economy. This may mean government might further push for a revival of government capex.
Second, majority of the activity will now be through the banking systems. i.e. the money flow would be accountable. Money which was out of the banking system i.e. excess cash will now enter the banking system in the form of deposits. Thus, in the short term, banks will be awash with liquidity. Aggregate bank deposits growth rate will rise.
Thus, with improved CASA (Current account & Saving Account) deposits i.e. lower cost of funds, banks may reduce their lending rates. Hence, benefiting various sectors and improving the consumer sentiments.
Third, this has created a fear among the black money hoarders. The parallel economy is expected merge with the formal economy.
There are talks that they may find ways and means to save some part of their unaccounted money. But this demonetisation move has created far more uncertainty in people's mind.
The fear of repeating the exercise will induce a behavioral change. That change would be a big positive for the economy.
While, the long term impact looks very promising and rewarding. The short term impact is severe.
The long queues, farmer's struggle for buying seeds, dropped consumer demand & sentiment are some of the issues that are really haunting and will take time to get resolve.
The exact impact on GDP growth is impossible to predict. It would be interesting to see how government deals with the short term hiccups and take this forward. We believe the recent announcement regarding the India's agreement with Switzerland to share bank information abodes well for demonetisation.
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