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Global Top Cat

India’s Curse of Cash

By Yiannis G. Mostrous, on Jan. 2, 2017

On Nov. 8, 2016, India’s Prime Minister Narendra Modi proved one more time that he’s not an ordinary politician when the government withdrew the legal-tender status of the 500- and 1,000-rupee currency notes.

These notes, which represented 85 percent of publicly held currency by value, must be deposited in banks by the end of the year. Removing the notes caused havoc. Cash amounts to about 14 percent of India’s gross domestic product (GDP), compared with an average of about 5 percent for emerging economies.

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The demonetization makes good on Modi’s promise to attack corruption and illegal economic activities while promoting digital banking and financial inclusion. Following through on these promises is quite a challenge. India’s formal economy represents only 15 percent of GDP, which explains why tax receipts as a percentage of GDP are low and why corruption levels are extremely high.

To a point, Modi appears indifferent to the political risk he’s taken. He’s only halfway into his term and important state elections are to be held next year. Perhaps the most vital of those elections is the one in Uttar Pradesh (UP). The state has a population of 205 million, more than 20 percent of which is Muslim. The outcome here could negatively affect the national standing of Modi’s political party (a Hindu nationalistic entity).

The sooner the issues stemming from demonetization are resolved, and they are being resolved relatively quickly, the better for Modi and his plan. Otherwise, the opposition and chattering class will gain momentum against his digital banking and financial inclusion initiatives.

Part of the opposition to the move to ban 500- and 1,000-rupee notes is that cash is used extensively in India during election periods to fill the buses with supporters for political rallies and buy votes. Given the busy election schedule next year, and the constraints demonetization will put on hoarding cash for use during elections, the opposition’s objections are easy to understand.

When it comes to the economy, demonetization will materially affect growth for the next six months. But the economy should experience a V-shaped recovery, with certain parts of the economy taking more time to recover.

Real estate should take the longest to recover, because it’s the sector where black money matters the most and on every level. From land purchase to sales of apartment units, most transactions are in cash and untracked.

Real estate transactions are often a 50-50 deal, with half the money changing hands under the table and half being on the books. The lower the value of the property, the higher the informal component of the transaction. A more expensive transaction is more likely to be audited, so a higher percentage of its price is paid on the table. Real estate accounts for around 90 percent of household wealth in India.

Another change that will affect the sector is the Real Estate Regulation and Development Act (RERA), which goes into effect within the next six months. The regulation requires developers to place 70 percent of cash proceeds from pre-sales into escrow until the completion of the project.

Development projects, therefore, will require more capital, even in only a temporary sense. Consequently, the sector will consolidate, with the financially stronger players absorbing the weaker ones. Nationally, more than 50 percent of the real estate developers currently in operation should disappear. In first-tier cities like Mumbai, the number will be close to 80 percent.

The broader economy also will be affected in the short term, as consumption slows and the investment upturn takes longer than expected to materialize. And that upturn will depend heavily on the government’s infrastructure spending, which is expected to reach 2.2 trillion rupees (US$30 billion) next year.

Sales of passenger vehicles will provide insight into the effects of demonetization. Car sales rose by 4.5 percent year over year in October and are up 8.4 percent year over year in the first 10 months of 2016. Many dealerships have offered discounts up to 20 percent to help consumers overcome the demonetization hurdle. The new numbers, due in January, should give a good idea regarding consumption.

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Demonetization has proved a positive for the bond market, with the 10-year government bond yield declining to 6.57 percent since the Nov. 8 demonetization announcement. Donald Trump’s victory in the US presidential election sent ripples through emerging markets, but India’s government bonds bucked the trend and rallied.

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Removing the 500- and 1,000-rupee notes will also drive a surge in bank deposits.

India remains the best long-term growth story in Asia; the recent pullback in the MSCI India Index is an opportunity to buy, rather than a reason to sell or stay away.

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That India’s stock market has held up relatively well amidst an absent investment cycle, tame credit expansion, relatively slow earnings growth and demonetization is an encouraging sign.

India’s economy will grow by more than 7 percent in 2017, while the stock market should outperform again as the earnings cycle bottoms out and the positive effects of demonetization filter through the economy.

The biggest risk is if Modi loses the general election in 2019. That would derail India’s economy.

In the meantime, India’s banking system is far ahead of its peers in recognizing non-performing assets. Financial institutions also continue to clean up their balance sheets and will benefit from an increase in deposits.

Furthermore, the odds favor a looser fiscal policy before the 2019 general election, likely at some point in 2017.

Indian equities could be volatile over the next two to three months, as short-term economic data will be weak. However, the stock market should deliver at least a 10 percent return next year.

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Yiannis G. Mostrous contributes his expertise in emerging markets and international equities to Capitalist Times in his Global Top Cat columns.

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