What does demonetization mean to the ‘aam investor’?

By  Harish Sridharan
Source: The Indian Economist 

Over the past week, a lot has been written about the demonetisation of the Rs. 500 and Rs. 1000 notes. The Prime Minister, Narendra Modi, made his announcement directly to every Indian, thus bypassing the media. Since then, the media has written about the effect of the move on black money, real estate and above all, the aam aadmi. However, the effect of this move on the financial markets, namely, the stock and bond markets, is left unexplored.

If the ‘aam investor’ thinks that the financial markets will continue to respond in the current manner, then s/he is grossly mistaken. While the markets may have fallen in value right now, in the long term, demonetisation is extremely positive news. 

The importance of cash

Demonetisation has eliminated 86% of currency notes in circulation (based on value) in one swoop.

As India is a cash driven economy, this move will cause an immediate fall in overall economic activity, leading to a fall in turnover for most of the sectors. This is especially true in consumer discretionary spending sectors such as luxury goods, apparel and two wheelers. To a certain extent, this can even apply to FMCG led non-imminent consumption related goods such as chocolates, shampoos and other items. This situation is unlikely to improve until the apprehension of cash being unavailable to more urgent needs gets alleviated. Hence, this will result in a sudden dip in Q3 revenues, and in certain cases, Q4 revenues.

The effect of demonetising is even starker when it comes to high ticket purchases. This statement is especially true when it comes to real estate and bullion purchases.

The effect of demonetising is even starker when it comes to high ticket purchases. This statement is especially true when it comes to real estate and bullion purchases. So far, most Indians have been investing an overwhelming proportion of their savings in real estate and gold. As a result, the average Indian household savings that lie in equity is one of the lowest among the major economies of the world. Another reason for the low equity penetration is the fact that large sums of money cannot be routed to financial markets without getting the money into the banking system. 

From real estate to equity

It is widely agreed that eliminating black money is bound to have a telling impact on the real estate sector. It is likely to lead to a sudden drop in demand forced by the lack of incentive to buy a second, third or a fourth property. This, coupled with a fall in the prices of properties, will lead to a stagnation of the market for the foreseeable future. The fact that there is excess supply in the market certainly doesn’t help.

As India is a cash driven economy, demonetisation will cause an immediate fall in overall economic activity, leading to a fall in turnover for most of the sectors. | Photo Courtesy: The Indian Express

This will have two outcomes, firstly, a lot of money will stay in the hands of the investors. This is the same money that would have otherwise found its way into real estate sector, thus artificially pushing up property prices. Secondly, and more importantly, money raised by selling the properties due to stagnating property prices will find its way into financial markets. This could happen through various routes such as mutual funds, direct equities and annuity products.

An increase in liquidity

India has a savings rate of 31%, which is among the best in the world. Savings rate refers to the ratio of money saved to the ratio of money earned. According to some economists, the savings rate is much higher when accounted and unaccounted income and investments are taken together.

According to some economists, the savings rate is much higher when accounted and unaccounted income and investments are taken together.

As the world has witnessed the effect of liquidity firsthand over the past decade, its effects need not be overemphasized. The additional investable surplus, coupled with a lack of incentive to invest in real estate will start driving up the prices of stocks and bonds. This would result in a virtuous cycle. Hence, there will more liquidity in the financial markets. Once an average investor starts experiencing reasonable returns more conveniently, investing in financial markets will become a more rewarding experience. This will happen due to advancement in digital and mobility driven investing models. Thus, compared to real estate, the financial market will deliver similar returns without the hassle of verifying documents.

Thus, demonetisation can trigger a long and sustained bull run in the Indian stock market. It can also deliver a buoyant and liquid bond market. When combined, these will make India a vibrant economy to invest in.

Hence, demonetisation has the potential to become the most significant economic decision for the aam aadmi.

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Harish Sridharan, an IIM-Ahmadabad alumnus, is a Financial Services Industry professional and is currently working as a product consultant in the lending practice of a leading BFSI Product company.

Featured Image Credits: Reporter India