InvestorQ : What were the major benefits to the Indian economy from the demonetization exercise undertaken by the government of India?
Mahil Khan made post

What were the major benefits to the Indian economy from the demonetization exercise undertaken by the government of India?

Abhisha Yadav answered.
3 years ago

There are different ways to look at it. Some consider the pain in caused while some consider that it did rein in black money. It also increased the liquidity with the banks. What are some of the key benefits of demonetization of currency notes. Let us look at some implications.

The big implication of the demonetization will be for the Indian banking sector. If you are wondering why Indian banks rallied sharply on Thursday, the answer lies in the fact that individuals are rushing to deposit their cash in the banks. This will result in a sharp rise in the float with banks. With restrictions on withdrawals, the banks are likely to be flush with funds. This could lead to a major re-rating of banking stocks, especially with a rapid increase in their CASA deposits.

Liquidity in the banking system will mean that the yields on the bonds will be headed downward. We already saw the yields on the 10-year G-Sec falling down to 6.70% on Wednesday and further down to 6.66% on Friday. A fall in yields will lead to capital gains on bonds and will benefit debt mutual funds immensely.

As yields head lower, this will bring down the cost of capital for Indian equities. Lower cost of equity will mean higher valuations and this will be positive for Indian stocks as a whole and help the markets re-rate higher.

Much of the money that was lying idle in cash will now enter the banking system and that has always been positive for Indian equity markets. We have seen in the past that whenever there has been a surge in liquidity, a good chunk of retail liquidity has gone into equities and equity funds.

Sectors like real estate and jewellery that have a large unorganized sector operating, will now be forced to operate more through banking channels. This demonetization will suck out a lot of liquidity that is lying idle and will provide a level playing field for organized realty and jewellery players who have been subjected to greater compliance compared to the unorganized market. While in the short run this will cause some pain for realty and jewellery stocks, it will be positive in the long run.

This demonetization will expand the tax base in India. For a nation of India’s size, our tax/GDP ratio is as low as 16%. This compares unfavourably with 24% for emerging markets and 36% for OECD nations. Greater tax compliance will reduce the black money in the system and increase the tax revenues of the government without burdening the existing tax payers.

Corruption has been the bane of the Indian economy. For many years, India has consistently ranked very low in rankings on corruption index. Corruption has a huge cost to any economy, which explains why corruption-free economies like Singapore, Denmark, Finland and Germany are so prosperous. Demonetization will help suck the corrupt money out of the system.

One of the key reasons stated by the PM for this move was to put strong curbs on funding of terrorism and anti-national activities. It is estimated that there is a large chunk of counterfeit money of higher denominations that is floating around in the economy and is being used to finance many sleeper cells in the country. This can be brought down in one blow through demonetization. We need to realize that terrorism has a huge economic cost and cutting off the financing pipeline is one of the best ways to curb terrorist activities in India.

For the economy as a whole this demonetization will be a major move towards a digital India. People will realize the futility of focusing too much on cash transactions and we will see a greater shift towards digital transactions using debit cards, NEFT, RTGS, digital wallets and UPI. This will make the economy less corruption-prone.

Lastly, we need to remember that this government has consistently focused on financial inclusion through the spread of Aadhar, Jan Dhan and Direct Benefits Transfer (DBT). Many of these initiatives can improve the living conditions of the population but they get restricted due to the expanse of cash transactions. This demonetization will be a big boost for financial inclusion and address the benefits to the last mile. In a nutshell, the demonetization will surely bring some short term disruption. But in the long run, it could be a game changer for the Indian economy.