On 8th November, 2016 the government made a shock announcement that Rs.500 and Rs.1,000 notes would be demonetized to curb black money, counterfeiting and fight terrorism. The move resulted in about 86% of the total value of currency being taken off from circulation.
It is also likely to have short and long-term effects on the economy. One reason for this is the impact on interest rates.
Banks have witnessed a great leap in deposits. This was mainly because of the short deadline for depositing currency notes during the said period. Around Rs. 5.5 lakh crore had already been deposited in banks till November 18, as per government data. This resulted in high liquidity in banks. In comparison, currency worth Rs. 1.03 lakh crores has been issued till November 18. Since it took weeks before the new currency to get into active circulation deposits increased.
Simple demand-supply economics, as the supply (deposits) increases, prices (deposit rate) fall. And that’s what had happened. Most banks had announced a cut. The biggest bank in India, State Bank of India, has shook Indian financial markets when they had announced savings bank interest rates cut by 0.5% from erstwhile 4% levels to 3.5%. As leader of the banking industry announced interest rate cut, several other banks have followed the suit.
Further, ICICI Bank and HDFC Bank have cut interest rates of Fixed Deposits by as much as 0.25%.
Yes, the demonetization caused deposit rates to dip, but there is other aspect to this story. Excessive deposits coupled with a poor demand outlook for credit will force lending rates to decrease too. This will be a gradual process and the number of people seeking loan at cheaper rates will slowly increase.
Lower demand because of the demonetization could exert a downward pressure on inflation in the near term. Similarly, categories such as food, housing and transport that have a higher cash component could witness a dip in prices. However, the government’s tax revenue is likely to increase. This could translate into higher investments and expenditure by the government. This could push up employment and incomes, and thus demand, in the long run. Hence, the impact on inflation—and thus interest rates—is expected to be neutral in the medium to long run.
If we consider the recent deposit data, during and even after the months of demonetization shows that Indians haven’t really cared to withdraw the cash that the government forced them to deposit in banks through the demonetization. In fact, deposits are still growing at a healthy pace of over 10% year-on-year.
The demonetization-induced deposits found their way essentially into current accounts that pay no interest and a small part into savings accounts (paying 4%) reason being individuals deposited cash into whatever account they held.
The year-on-year growth in time deposits averaged around 9% before demonetization and rose to 14% during the demonetization months. Since then, the growth has been flat at 10%. But growth in demand deposits rose exponentially to 25% during demonetization and has averaged 26% in the coming months.
This shows that demonetization resulted in a permanent improvement in bank deposits while not really inspiring large withdrawals among people in its aftermath. This is why demand deposits are still 26% higher than they were a year ago because whatever money was deposited in banks remains there.
The Reserve Bank of India, in an internal study, estimated that excess deposits in banks during the 50 days of demonetization worked out to Rs4 trillion. Even after considering some tapering off in the two months following demonetization, the excess deposit works out to not less than Rs. 3.5 Trillion.
Increased deposits in bank accounts is also soften bond yields and also lower rate of interest in the economy as banks were forced to use the extra cash to buy more government papers and to lend money to customers, or do both. With people unable to spend due to tight liquidity, this could also lead to slower growth, which would leave enough space for the RBI to cut rates.
Context of Indian Markets
Indomitable is the word that strikes us when we choose to talk about the Indian markets. The prominent indices have shown an ascent of over 20 percent this year, which makes India one of the best performers in Asia. DIIs have trumped FIIs by injecting roughly $7.2 billion in 2017 while the latter have bought almost $7 billion.
Indian mutual funds that were long absent from the buzzing scene of the Indian markets are having a gala time this year with contribution not only from the top tier cities but some lower cities which are very new to mutual funds
India is finally making a paradigm move from just physical savings to investment. Indians have always set store for investing in tangible assets like property, jewelry or gold. But if we go by the investment figures of last year we can see it outdid physical savings. The very steady housing market may be responsible for this. The government's overnight withdrawal of 86 percent of India's currency last year may also have increased the appeal of digital transactions.
But, Indian Policy makers have tried to induce some trust in the country towards directing their savings to investments in financial markets. Indian households for whom stock markets were a virgin territory were induced to explore different financial instruments in a course to invest. Since there is a rise in the retail investors or the DIIs, they have been able to compensate the FII outflows.
The Government by now has already spent over 90 percent of its fiscal deficit for the year. Still ambiguous new indirect tax regime, the Government is on the lookout for finance to flow in for its ambitious infrastructure plans which is up for execution in the near future. Indian households, heavily loaded with savings, are looking for safer avenues of investments. The government wants to induce more and more individuals towards stock market, which is the most lucrative investment avenue in the future to come.
Equities vs bank deposits
is true that equities are the riskiest and volatile of all assets, but facts state that equities provide the highest return over the long term, if calculated-and-informed-risks are taken with proper selection of stocks and at the right time. However, returns are not the only aspect of the stock markets. Let us take a look at the advantages from the stock market which induces an individual to invest in the same.
· Hedge against inflation: Generally, in the longterm perspective, equity investments have proved to be the smartest asset classes providing a high return which offsets the negative effects of inflation.
· Affordability: Even for a person with low income, an individual can start with stock markets with a very low amount. Equity mutual funds are the cheapest investments available out there for people who cannot track stock markets regularly and also provides them with tax benefits in the long run. The minimum investment in Mutual Funds is Rs.500.
· Liquidity: Because a large number of investors buy and sell their stocks on a regular basis, which makes equities a liquid investment, unlike other assets which take some time to sell. For instance, if you want to sell your property, it may take a great deal of time to find a buyer.
· Tax Benefits: Stock investments in India enjoy various tax advantages. Dividends and long-term capital gains are tax free.
This is, however, dependent on a disciplined investment approach and a great deal of research with robust understanding of the market.