Why is the currency ban causing markets to rise?

We should expect to see an impact on business and growth in the short term as a large part of the business is cash-based


Hemant Mishra/Mint
Hemant Mishra/Mint

The sudden shock of the currency ban and an unexpected election result in the US caused markets to open 6% down on 9 November. But a day later, the story has changed—all markets are up. So why are stock markets surging? Why are bond markets happy? Why are real estate magnates walking like zombies? What lies ahead for your money?

Readers of this column are hopefully smug with their financial plans and asset allocation in place and are not wasting time wondering if stocks are a good ‘bet’. But let’s deconstruct why markets are up on Day 2 of the #currencyban. Day 0 was 8 November, when Prime Minister Modi made his #currencyban address to the nation.

I spoke to several mutual fund chief executive officers (CEOs) to understand this better. And this is what I got: there are about Rs14.2 trillion worth of Rs500 and Rs1,000 notes in circulation. People holding them will do three things.

One, burn them. Already there are stories of sacks of old notes being burnt in Uttar Pradesh. Whether these notes were real or fake, nobody will ever know.

Two, spend it. Gold prices have zoomed overnight as people turned cash into gold. Those who can’t account for the money have gone on a shopping spree and bought high-end products like branded clothes, bags, shoes, gadgets. The Mother Dairy provisions booth (which sells fruits, veggies, daal, sugar, oil and such like) near my house was cleaned out on Day 1 of the #currencyban. What happened? One lady came and bought Rs40,000 worth of sugar. A man bought Rs80,000 worth of oil. One bank manager wanted to deposit Rs5 lakh cash with the booth guy, to buy stuff for the rest of the year. A similar story must have played out in many other places. People used cash to hoard whatever they could—gold, silver, art, gadgets, non-perishables.

Three, deposit it in the bank. Even if half of the Rs14.2 trillion gets deposited—the rest gets spent or destroyed or remains hoarded—Indian banks will suddenly have a giant surge of liquidity. Once deposited, it is unlikely that the money will get withdrawn at once. One estimate puts the gain in deposits at Rs3-4 trillion. This wave of liquidity will cause deposit and lending rates to fall. Falling deposit rates will push money towards other asset classes. Real estate is unlikely to be the destination till prices correct even more. As an aside, real estate is going to remain comatose for some more time, so don’t rush into buying just yet. Gold is another destination of the money, but smart investors know that gold is at best a store of value and a hedge against inflation. Money is flowing into stocks and bonds because banks will be forced to start lending when they sit on such a huge stock of cash. Stock markets are rising as they are anticipating a fall in interest rates, and a rise in lending by banks on the back of a wall of liquidity never seen before. Bond prices have risen, and some debt funds should show nice capital gains, due to the anticipation of a fall in interest rates. As one CEO put it: the worst has happened. Globally and locally. Markets have factored in the US Federal Reserve rate hike. It will now be a positive domino effect.

Another larger story is playing out, says one of the CEOs I spoke to. “If we assume that Rs5 trillion of black money is destroyed, then that is a reduction of the liability of the Reserve Bank (of India). It can pay dividend to the government now or over the next 2-3 years of this amount. The government can address issues of deficit and improve its global ratings. Then there is the additional Rs40,000-60,000 crore of penalty money that will come the government’s way. But remember, all this is assumption; we need to discount the ingenuity of the Indian chartered accountant to turn black to white.”

What about real estate? Don’t expect a revival very soon. When graft generates illegal cash, it needs to go somewhere. In India it has gone into real estate and gold. Real estate prices in India have been high due to the graft at every level—from land acquisition to construction. A clampdown on corruption will reduce business in the short run in real estate, but we should expect prices to fall. How far? The current yield (annual rent divided by market price) on real estate is about 2-2.5%. You get 4% interest on a bank deposit. People buy real estate hoping for capital gains. But these are not anywhere on the horizon. Prices should fall so that your yield is at least 4-5%. Once you get to that, begin thinking of buying. Not yet.

So all is rosy ahead? No. We should expect to see an impact on business and growth in the short term as a large part of the business is cash-based. Especially, the traders and small businessmen will see rough days ahead. In addition, high-value consumption goods—gold, art, and real estate—were all cash-based. This spending will suddenly dry up, impacting growth. But most experts said that it is short-term pain that we need to bear. The war on corruption is good for us in the long term. It is good for growth as the parallel economy is finally a drag on the economy.

What we need to remember is that the #currencyban is not just a sudden one-step action against corruption. This is a part of an overall plan to check graft and the parallel economy. What should you do? Carry on with your plan. If you don’t have one, it is a great time to become a part of the financialisation of the Indian economy.

Monika Halan works in the area of consumer protection in finance. She is consulting editor Mint, consultant NIPFP, and on the board of FPSB India. She can be reached at monika.h@livemint.com.

READ MORE