Topic: Impact of Demonetization on Indias Financial Sector

Partha Sarathi Barman

Enrollment No. BAM16027
Department of Business Administration
Nilachal Mens Hostel
Email Id: parthasbarman@gmail.com
Ph.no. +918876658776
Demonetization: What it is?

Demonetisation is a radical monetary step in which a currency units status as a legal tender is declared invalid. It is
mainly done when there is a change of national currency, replacing the old unit with a new one. Demonetization is
necessary whenever there is a change of national currency. The old unit of currency must be retired and replaced with a
new currency unit. It is not a new topic or new thing, previously we have seen many cases of demonetization, one of
them was when the European Union nations decided to adopt Euro as their currency, but they give their citizens sufficient
time to convert their old currencies into Euro, so that transition will be smooth from old to new currency.

When Demonetization comes in to play?

Due to various reasons nations demonetize their local units of currency, some of them are-

to deal with corruption, scam, black money, terrorism

to fight with inflation
To lower the cash circulation in the country which is directly related to corruption in our country,
to stabilize the economy
To eliminate fake currency and dodgy funds which have been used by terror groups to fund terrorism in India.

Demonetization and India:

In current Indian scenario, demonetization is a burning topic, in India everyone heard about it, and have some knowledge
about it. This happens due to the steps taken by Government of India, on 8th November, 2016 Indian government decided
to demonetize the 500 and 1000 rupee notes, the two biggest denomination notes in India that time. In Indian context it
was not the 1st time to ban certain currencies all of a sudden. It has been implemented twice 1946 and 1978 in the past.

In 1946, the currency notes of Rs 1,000 and Rs 10,000 were removed from circulation. The ban rarely had impact, as the
currency of such higher denomination was not accessible to the common people.

Again in 1978; the then Prime Minister of India Morarji Desai announced the currency ban taking Rs 1000, Rs 5000 and
Rs 10,000 out of circulation. Main aim of that ban was to remove black money from the country.

In a financial historic move of the Indian PM, that announced to demonetization of Rs 500 and Rs 1000 notes starting
Nov 9th 2016. It was welcomed by people across the country, but has given shock to many. The Prime Minister urged the
people to support the move while asking them to bear the pain for 50 days to help him deliver the India of your
dreams.

Due to this demonetization, Indias financial sector was badly affected, it influenced the whole economy of the country.
So here mainly we will discuss about the impact on Indias financial sector due to this demonetization.

Impact on Indias financial sector:

India is majorly a cash-based economy and close to 98% of the total transactions by volume and 65% transactions by
value are done in cash. So when there was a shortage in cash happened, it affected the whole economy. India is the biggest
cash intensive economies of the world with Cash to GDP ratio of 12%. i.e. the value of notes and coins in circulation as
a percentage of GDP. According to our Govt. Parallel shadow economy eats away the vitals of our economy by give
fuels to the inflation and also deprives government from its legitimate revenues.

So the quick impact points are,

It will push up the demand for gold as safe store of wealth. This would result in gold imports and it
will impact balance of payments.
It will push up the demand for dollars as safe store of wealth.
People would be happy to pay the charges/commission for converting black money into gold and then
reconverting it into rupees. The same stands for dollars of other foreign currencies.
It will be a big boost for e-wallets. E-wallet is an online prepaid account where one can stock money, to be
used when required. You can pass on the benefits of your e-wallet to your friends and family as well.

So from these quick facts we can see the quick outcome of this effect, but if we see the impact in sector wise, it will be
easy for us to get a holistic picture.

Impact on Banking Sector: The move towards a cashless economy will boost savings in financial assets. As directed by
the Government, the 500 and 1000 Rupee notes, which now cease to be legal tender are to be deposited or exchanged in
banks (subject to certain limits). This will automatically lead to more amounts being deposited in Savings and Current
Accounts of commercial banks. This, in turn, will enhance the liquidity position of the banks, which will be later utilized
further for lending purposes. With any sharp infusion of deposits and relatively limited avenues to lend, the credit deposit
ratio for banks would become unfavourable, and thus impact margins.

Impact on Indias Economy & GDP: The aim of demonetization was to wash away black money from the country and
ensure India is banked and tax paying country. Some feel that demonetization will be a long term benefit as it is will help
in having a spurt in the Indian economy, not everyone believes in this theory. For the last two quarters countrys economy
and GDP was unpredictable and reports from various sources were different, Govt. shows a healthy report but those
report are not satisfying. Finance Minister believes the GDP of the country is expected to grow as there are many financial
transactions which do not fall into the category of economic activities. The positivity around the demonetization is, there
is hope that on the long term there is a lot of benefit from this move. Though at this point are suffering due to sudden
changes in the economy.

Impact on Non-banking financial sectors and Micro finance institutes: NBFC-MFIs have started to go through the face
of loan defaults due to demonetization. This has led to temporary increase to the non-performing assets of the institutions.
Its not just the asset quality that is being impacted with this chain reaction but also earning capacity of these institutions
is at great threat. Daily wagers and low income earning people are not able to pay the dues on time due to lack of
availability of money in hand. Mobilizing collections is the greatest challenges from retail customers after the withdrawal
of Rs. 500 and Rs. 1000 notes from the Indian economy. NBFC and Micro-Finance institutions are turning hesitant to
lend to those who do not have bank accounts. This measure is taken by them to ensure timely collection of payments,
but lack of alternatives is turning its retails customers away. The main customers of most of the NBFCs and MFI are
small customers like farmers and labourers. Thus there is argument to allow NBFCs and MFI to exchange Specific Bank
Notes (SBN) to its rural customers. This will help in having liquidity and defaults and late payments can be brought into
control. Unintentional defaults will no more be a reason why there is less liquidity or down fall in the NBFCs and MFI.
Apart from these, there should also be some relaxations on the withdrawal limits for these institutions to promote its
growth and stability in the current market.

Impact on Indias Inflation: The RBI (Reserve Bank of India) considers the CPI (consumer price index) as its primary
gauge of measuring inflation. Prior to the RBI adopting the CPI in India (PIN) (FINGX), another measure of inflation
the WPI (wholesale price index) was the key gauge of inflation and its still considered for reference. The RBI has CPI
growth targets to adhere to while deciding its monetary policy stance. By January 2016, it was supposed to keep inflation
below a target of 6%, which it was able to do. Its next target is to keep inflation at or below the 5% mark by March 2017,
according to govt. current inflation rate is 1.86%, which is quite low by the mark of 5%.

Impact on Debtors: Debtors and borrowers who are involved in legal transactions need not worry about
demonetization. For this category, there will be no impact through withdrawal of high demonetization currencies. Only
difference would be repayment of debt will be through online transfers or cheques to bank accounts instead of cash
payment. Those debts and transactions that were given outside the eyes of law will come into the light when these are
being cleared. As it is difficult to transact through cash, individuals will have to repay the debts through banks
accounts. Any transaction that is suspect-able or not accounted legally will have to be explained by the individual.

Impact on rate of loan: Rates are already on the decline, after the demonetization announcement on November 8, Indian
banks saw a rise in deposits. According to data from the Reserve Bank of India released on November 21, deposits
crossed the 5 trillion-rupee mark from November 10 until November 18. At 68.2 rupees to one US dollar, it translates to
$75 billion in deposits in just eight banking days. Banks also saw a rise in term deposit accounts since the demonetization.
Due to these factors, commercial banks like State Bank of India, ICICI Bank (IBN), HDFC Bank (HDB), and Punjab
National Bank, among a host of others, sharply reduced their deposit rates. Apart from cutting deposit rates, banks
reduced their lending rates as well. In India, loans sanctioned from April 1 are with reference to the MCLR (Marginal
Cost of funds-based Lending Rate), instead of the Base Rate, which was used earlier. It will translate into lower interest
rates on existing floating rate loans and new loans. The reduction in lending rates is expected to stoke lending by tempting
consumers to take out loans for purchasing expensive consumer discretionary items like vehicles and houses.

Impacts on Financial Markets: Equities fall, but prospects are better; Indian equity markets have been on a near secular
falling trend since the government demonetized the 500 rupee and 1,000-rupee currency notes after midnight on
November 8, 2016. The two benchmark equity indices the Nifty 50 and the S&P BSE Sensex fell on each trading day
since the demonetization except for November 10 and November 22. While the Nifty 50 fell 6.3% from November 8
until November 22, the S&P BSE Sensex fell 5.9% during the same period. Due to the rise in the US dollar, the dollar
equivalents of the Sensex and the Nifty fell more than 8% each. The S&P BSE 100 Index, which is comprised of 100
stocks compared to the Sensexs 30, fell 6.6% during this period. Mid and small-cap indices have been hit much harder
than broader market indices.
Impact on Business: By the second week after demonetisation of 500 and 1,000 banknotes, cigarette sales across India
witnessed a fall. The demand for point of sales (POS) or card swipe machines has increased. E-commerce companies
saw up to a 30% decline in cash on delivery (COD) orders. Several e-commerce companies hailed the demonetisation
decision as an impetus to an increase in digital payments. They believe that it would lead to a decline in COD returns
which is expected to cut down their costs. E-payment options like PayTM and Instamojo Payment Gateway, PayUMoney
has also seen a rise.

Impact on Indian Rupee: The Indian rupee fell against the US dollar. Given the pressure on the local unit and its relative
stability, it seems like the Reserve Bank of India has been working hard to keep the currency stable.

Impact on black money: Only a small portion of black money is actually stored in the form of cash. Usually, black income
is kept in the form of physical assets like gold, land, buildings etc. Hence the amount of black money countered by
demonetization depend upon the amount of black money held in the form of cash and it will be smaller than expected.
But more than anything else, demonetization has a big propaganda effect. People are now much convinced about the
need to fight black income. Such a nationwide awareness and urge will encourage government to come out with even
strong measures.

Impact on Payment Banks: Post demonetization, India got its 1st payment bank, thanks to Bharati Airtel. Paytm is also
following the road of Airtel. It is sure that other organization will also try their luck in this sector in near future. Payment
banks which are part of the transaction ecosystem are likely to be long term beneficiaries, as more and more cash finds
its way into the formal banking channels. Govt. believe the cumulative measures taken to reign in black money will
improve banking habits, create financial and transactional history of the informal & cash dependent segments and could,
over the long term, make them bankable.

Impact in Investment in Financial Products: Investors in the short term will now believe that Cash is not the safest asset
and there is little point in hoarding it. This will shift them from physical asset to financial assets where returns are also
higher.

Impact on Bond Markets: Surge in deposits will create more demand for government bonds and other high rated bonds
in a situation of tepid demands for credit, leading to lower bond yields especially in the shorter end of the curve. We
believe that the RBI will continue to sterilize excess liquidity from the banking system to keep the short term rates aligned
with the policy rate.

Impact on Online Transactions and alternative modes of payment: With cash transactions facing a reduction, alternative
forms of payment will see a surge in demand. Digital transaction systems, E wallets and apps, online transactions using
E banking, usage of Plastic money (Debit and Credit Cards), etc. will definitely see substantial increases in demand. This
should eventually lead to strengthening of such systems.

Impact on Cash: The scarcity of cash due to demonetisation led to chaos, and most people holding old banknotes faced
difficulties exchanging them due to endless lines outside banks and ATMs across India, which became a daily routine
for millions of people waiting to deposit or exchange the 500 and 1000 banknotes since 9 November. ATMs were
running out of cash after a few hours of being functional, and around half the ATMs in the country were non-functional.
The above mentioned sectors are mainly those sectors which are influenced heavily by demonetization. There are other
sectors also, but due to the limitation of words Im not taking those. Everyone thought that Indias demonetization
initiative was a total chaos, this doesnt mean that the entire endeavour was a complete failure. PM urged his country
people to give the govt. 50 days to handle the demonetization, and after that period I think everyday life came back to
normal and I personally think that govt. was pretty able to handle the situation. Although People faced service failure
like ATM failure etc. in those 50days. But day to day life is pretty normal now. After these two quarters we have seen
some pros and cons of the Demonetization. Positive sides are like cashless economy rise at its best, black market saw a
temporary breakdown. This process has also taken care of fake currency problem. It was thought that there were 250
million of rupees of fake currency was present in the system before the demonetization. So I think govt. was quite
successful to take down those moneys.

But there are some down side of this practice. Some of them are like farming sector taking a hit due to lack of cash.
Replacing cost of the 500 and 1000 Rs notes are quite high. As well as its also increased the costs of operating ATMs.
Main drawback is that big fish left out, whose black money was in the form of foreign currency, gold and stashed
away in tax havens. But the main thing is that the Pros which are in the long term interest of the country comfortably
outweigh the cons.

In this regards I think one of the saying of Raghuram Rajans is very much applicable

We are neither hawks, nor doves. We are owls. The owl is traditionally a symbol of wisdom.

We are doing what is necessary for the economy

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