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Demonetization – RBI – Government Of India v/s Dalal Street

Jan 13, 2017 | 10 minutes |

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November 8, 2016, was the historic day when the Prime Minister of India – Mr Narendra Modi announced a 50-day drive towards demonetization of the already printed old Rs. 500 and Rs. 1000 currency notes effectively from midnight of that date. The demonetization drive was basically put in action to end the fake currency circulation of the high denomination notes in the Indian economy and as a strict measure against the parallel or black economy. Since the announcement of the demonetization, people holding a huge chunk of black money have been finding innovative ways to safeguard their wealth. Some seem to have found out ways to safeguard a substantial part, while others chose to declare their wealth and bear the fines. On December 31, 2016, the Indian Prime Minister had addressed the nation as the 50-day Demonetization drive initiated by the government was completed. Mr Modi laid out several major incentives mainly for the poor, the farmers, women, pensioners and small scale business people. Soon after the PM announced bank related incentives for these segments, several banks had cut their Marginal Cost of Funds Lending Rate (MCLR) with SBI leading the pack by cutting MCLR by 0.9% Other PSUs like Punjab National bank and Union Bank of India have announced a cut in the lending rates. India’s largest private bank ICICI too cut its lending rates by 70 bps or 0.7%. Narendra Modi had earlier indicated that the budget shall be presented 1 month in advance. On January 4, 2017, the government declared that the Union Budget 2017-18 will be presented on February 1, 2017. So now the question troubling investors and traders is, with these developments in place, will the stock market see a huge bullish run before the budget is presented by the Finance Minister? Traders would be hungry for an opportunity to book quick profits, while investors may be seeking that golden moment to enter the market for long term. Writer’s Analysis on this Scenario Expectations in the Indian economy
  1.  More than 85% of the market participants including the majority of the economists were expecting a cut in the repo rate of 25 bps. during the Reserve Bank of India’s bi-monthly policy meet on December 7, 2016. About 23% of those participants showed over-optimism and even expected a cut of 50 bps. because the CPI numbers that were released few days before the policy meet were well within the central bank’s target. The main reason for the CPI figure remaining in limit was that food inflation was low and within the expected range as a result of a good normal monsoon. The OPEC members had still (i.e. before the December policy meet) not reached a consensus to put a cap on the oil output sighting uncertainty from Iran’s and Russia’s stance. This kept oil prices well below $50 per barrel, which was in turn good for the Indian economy as low import prices mean lower import bill for the Indian government (oil prices make up about 80% of the government’s import bill). Thus, two main components – food and fuel, which have more than 50% weight in the CPI basket of goods seemed well under control. Also in its policy meet in October 2016, RBI governor Dr Urjit Patel had stated that the neutral real interest rate in India is now 1.5 – 2.0%. This may also have raised expectations of the market for a probable rate cut during the December policy meet. However, RBI did not cut the rates and that had probably led to a dissatisfaction amongst the market players.
  2.  Soon as the demonetization drive was initiated by the government, the economy was seeing a tough situation with liquid cash getting dried up in the country as the currency notes of 500 and 1000 denominations, which made up 86% of the total cash notes circulated in the economy were no longer valid. The industries directly and indirectly related to the consumer markets – mainly the FMCG industry, were facing a tough time as potential consumers queued up in front of ATMs and banks to either exchange or deposit their old notes. Consumer goods market saw a substantial hit because of the demonetization drive – So much that analysts and domestic as well as international investment firms now revised India’s expected FY 2017 GDP growth down to 7.0 – 7.2% from the previously expected 7.6%. This was the second reason for the market players to expect that RBI may go for a rate cut so as to stimulate the state of the economy and to support growth at pre-determined levels.
What may have kept RBI from cutting the interest rates on December 7, 2016 Writer’s Comments Taking into consideration all the factors, it seems that in this less-than-one-month period before the Budget, economic activity will start getting back to normal with the new currency notes accelerating back into the economy as they replace the old notes. As per the recent developments, the U.S. shale production will be increasing in the coming months though the OPEC members have agreed to put a cap. This may pose a threat to the commitment of OPEC and there is a possibility that the leading oil producers like Saudi Arabia and Iran will refrain from limiting their oil output in order to retain their market share, which will lead to Russia becoming active in the oil market again to retain its own market share. This may drive the oil prices back to sub $50 a barrel levels which are a possible big cheer for an oil-importing country like India. On December 31, 2016, when Mr Narendra Modi addressed the nation to thank the citizens of India, he especially thanked the bankers for taking due pain during that period and also announced several bank related incentives as stated earlier. With this, he gave several indications towards the possible incentives in the 2017-18 Union Budget that is scheduled to be presented on February 1, 2017. The leading public and private banks in India had recently passed on the rate cuts to common people by slashing their MCLR substantially. But in the next RBI policy meet scheduled on February 8, 2017, I expect the RBI shall maintain the policy rates at the current levels, reason being that RBI may monitor the activity in the economy after demonetization for quite some time and until the results of demonetization are measured, it would be difficult to take major decisions. Also, the recent benefits of rate cuts that have been passed by the banks shall be monitored for some time. In case RBI cuts rate in the February meet, there shall be an oversupply of stimulus in the economy because of back to back events happening, which can be a potential driver of inflation, which is again bad for the economy in a long run. We should never forget the case of the U.S. Housing Bubble that happened as the U.S. Fed provided an oversupply of monetary stimuli by aggressively reducing the rates following the Dot-com bubble and the 2001 World Trade Centre attacks, which ultimately led to the 2008 Global Financial Crisis. In this scenario, I expect the market to remain range-bound at the current levels with a few upward and downward fluctuations or move slightly upwards by about 2% from the current levels till February 1, 2017.   --------------- About the Author: Harsh Pathak

The writer can be reached at pgpb05.34@misbbocconi.com
Student and Core-Committee Member of Finance Club, MISB Bocconi
First appeared on http://misbfinance.blogspot.in/