By Charles Walsh
I spent last week in India meeting companies, analysts, government officials and industry experts. It was a fascinating time to be in the country, being just days after the government’s surprise decision to make the bulk of outstanding cash non-legal tender. For those interested, I have detailed some of the key points of this ‘demonetisation’.
Demonetisation – the term given to the withdrawal from circulation of 500 and 1000 rupee notes – dominated last week’s meetings. Many opinions exist as to the impact of the move, the reality being that the long-term effects will depend on the implementation of the transition over the coming weeks and months. So far, the implementation has been disastrous – quantities of new notes to replace those coming out of circulation have been woefully inadequate, ATMs are for the most part yet to be recalibrated to supply the new notes (why they needed to be a different size no one can explain) and there is little known about what will happen to those depositing larger quantities of currency (over Rp250,000 or roughly $3,700), said to bring closer inspection from tax authorities.
The short-term impact on activity has been brutal. Business activity has ground to a halt. Wholesalers are operating at around 10% of their usual levels with retail operating in the region of 25% of the norm. Taking 86% of banknotes out of circulation in an economy where 80% of transactions are in cash is always going to hurt. The impact outside of tier 1 cities (of which there are only four) has been the most severe. In rural areas, most do not have access to ATMs and many are still without bank accounts, despite moves to improve financial inclusion through the issuance of ID cards linked to accounts with state-run banks. This means people having to travel to nearby towns to hand their money into banks and attempt to get replacement funds.
People have been forced to queue at banks and ATMs for many hours to deposit their cash and withdraw small amounts of new notes. As of Thursday 17th, nine days after the measure was announced, 43 people had died whilst queuing for replacement currency. Fresh cash withdrawals were initially limited to Rp2,500 per day, a limit that was increased to Rp4,000 but then subsequently decreased again to Rp2,500 as adequate supplies of the new notes failed to materialise.
The problems have been compounded by the fact that initial supplies of the new Rp2,000 note were effectively useless as no one was able to get change when attempting to spend them, a key government oversight in the implementation of this exercise. The new Rp500 notes were not introduced into circulation until 16 November, eight days after the old notes were banned; even then supplies were severely restricted.
Despite the short-term inconvenience, most are prepared to wait patiently in the queues on the basis that this is for the greater good, accepting that clamping down on corruption and terror funding is worth the near term pain. Certainly, the behaviour of the general public has been more dignified than that of the politicians.
From a business perspective, the negative impacts are likely to be greatest in the property and gold sectors, generally accepted as the most driven by ‘black’ or undeclared money. Most property purchases contain a cash element and much construction activity operates on cash payments so it is easy to see the negative impact here. This may prove especially problematic – roughly 10m people currently join the workforce each year with only around 5 million jobs being created. Private investment is practically non-existent and unlikely to pick up within the next year or two given low levels of capacity utilisation. This has made the property construction sector the biggest generator of jobs in the economy. Already in a downturn, owing to falling transaction volumes and increasing regulation, demonetisation is likely to deal a crushing blow to the sector. Property prices are widely expected to fall, with many predicting a 50% decline in values. This expectation alone will likely lead to a collapse in transactions as buyers pause and sellers reset their expectations. The next one or two quarters are likely to see a sizeable drop in activity.
Longer-term the move to bring cash transactions into the formal economy is likely to be positive. Tax revenues should increase (currently only 5.5% of Indians pay income tax), interest rates should fall and the banking system will see a boost in low cost deposits and thus ability to lend. But reallocating funds from the private to the public sector is unlikely to have a near term positive impact on activity. Public spending was already the only driver of growth and even if it picks up further it will do so with a lag. There is speculation that the government will benefit from a ‘dividend’ from the central bank as it is expected a large proportion of black money won’t make it back into the banking system and the liability could technically be written off. It is doubtful that this will prove to be the case, as legally the liability will still exist and if it were to be extinguished it would represent a de-facto expropriation of assets.
There is an innate optimism in India (earnings don’t fall, they de-grow), which biases people to look for the positives in demonetisation. However, India inc was already facing problems of low private sector activity and investment, overcapacity, weak earnings growth, a worsening NPA cycle and rising unemployment. Demonetisation is only likely to make these worse.
Whilst we see headwinds for India that lead us to being currently underweight the country, we are more constructive on the outlook for Asia ex-Japan and global emerging markets as a whole, seeing many opportunities for our bottom-up stock-picking approach to generate outperformance.
Charles Walsh is an analyst portfolio manager, global emerging markets at Mirabaud Asset Management
