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SPEED READ: India is our Best Buy in EM. Demonetization means a move towards a cash-less society – that is not what has happened in India (yet). It is what Mr. Modi aims to achieve. ‘Re-denomination’ (swapping old notes for new) is what has happened thus far, and the liquidity shock it created is already reversing, creating three opportunities. First, a political monetisation: much like China’s anti-corruption drive, Mr. Modi has crushed political opponents and the property lobby. Second, a policy-mix monetization: fiscal revenues will get a larger share of the pie, while monetary easing will ensure that the pie doesn’t become smaller. Third, monetizing the market opportunity as the near-term, liquidity shock is already reversing, banks have cut lending rates a bit already, the RBI is very likely to step in, and India’s resource allocation will improve. The biggest unknowns? (i) Why was the 2000 Rupee note introduced? Probably so that it too can be withdrawn post-election. (ii) What further measures are in the pipeline?

Market implications: Indian equities and FX are our Best Buy in EM, and there is value in the rates space too. The retail shock is reversing but public banks with links to property developers will remain under pressure. Both the front- and the back-end of the yield curve are good value, with 75bps of cuts by the RBI likely. Oil price increases are a concern, but not as much when core inflation is falling and risks to demand remain. USDINR remains harder to call because the USD will call the shots (see our note on rising US rates and a stronger dollar), but the INR along with the RUB will be EM outperformers.

Money, it’s a crime, share it fairly but don’t take a slice of my pie. Money, so they say, is the root of all evil today – Pink Floyd, 1973

Who knew Mr. Modi would turn out to be a Pink Floyd fan! Other fans, we hope, will forgive our final sentence.

I spent two weeks in India and tried to get a sense of the damage that this shock has left behind. I was immensely surprised to find three things: First, the liquidity shock is reversing, the bias in the media coverage isn’t. Second, most critiques are terribly short-sighted – I have yet to hear a sound, structural argument against what Mr. Modi has done. Even though the ongoing pain and poor implementation are true enough, there is more to both issues than just the headlines (as we explain below). Third, very few media sources are reporting the support this move has received. Don’t be fooled into thinking (as The Independent argues) that this is because Mr. Modi is hiding behind a veil of ‘fighting corruption’. The Congress party tried that – and failed!

So what are the new ground rules and new realities? Is there something to be monetized from this shock? What’s next – what could go wrong?


This isn’t de-monetization (yet), this is re-denomination Re-denomination, not demonetization, is a more accurate term for what has happened thus far – demand deposits automatically and legal cash-in-circulation via banks are switching to the new legal tender. The latter takes time and is the painful bit.

But demonetization, Mr. Modi’s longer-term goal, is being pushed aggressively too. In his New Year’s address, Mr. Modi has already announced a tax cut on e-payments and a publicity campaign is also underway.

The large, near-term re-denomination shock is already reversing. It was in part a demand (liquidity) shock because the re-denomination affected 86% of the cash-in-circulation, and in-part a supply (labour) shock as millions of worker-hours were spent waiting in lines to make that change.

Not any more. Lines at banks had shrivelled well before the 30th Dec deadline (ii) Daily and weekly withdrawal limits (50 and 250 GBP respectively) are now high enough (iii) Government banks have cut lending rates 9 bps already (iv) Retailers are now handing back change, which was not the case in Nov and early Dec.

Couldn’t implementation have been better? Sure, but secrecy was more important, and that was the really impressive part. A small team of five and some support research staff led by Mr. Adhia (Mr. Modi’s trusted lieutenant from his earlier days), worked out of Mr. Modi’s residence for months to ensure there were no leaks. Had more elaborate arrangements to create an efficient transition to the new tender been made, secrecy and therefore effectiveness of the shock would have been severely compromised.

Is there a medium-term effect? Yes, both negative and positive. There is a more persistent, negative demand shock because a large chunk of the undeclared or illegal portion of total cash-in-circulation will not be exchanged for the new legal tender (there have been two tax amnesty schemes already, and no more are likely). Most property transactions in India had an undeclared cash element to it (to avoid taxation) that made property investment and construction more appealing. The cash element is not taxed, but it is either spent or is part of household wealth. If such cash is now pulp fiction, then there is a permanent shock to spending. If cash transactions in future property deals are much smaller, then future untaxed cash flows will also create less spending, implying some persistence in the shock. The magnitude, unfortunately, is hard to calibrate.

A positive counter-balancing effect exists. Some of it is already materializing… Tax revenues are significantly higher. Union Minister Mr. Jaitley recently announced that direct and indirect tax collection were up 14% and 26% till November 30. How much of the level increase becomes permanent remains to be seen, but there is at least some cushioning for the near-term to counter-balance the shock to economic activity.

…and some more will slowly over time as well. The economy has essentially been paying a ‘corruption tax’ and providing a subsidy to for the undeclared portion of property transactions, and for all illegal cash transactions. As the ‘true’ tax rate becomes applicable to a greater volume and proportion of transactions in the economy, the corruption tax falls. This is a slow-moving, positive supply shock that will be disinflationary.

Is this really a regime change? Yes, for two reasons. Fighting corruption in a data-rich environment China’s anti-corruption campaign has dragged on because it is based on targeted, individual campaigns. By contrast, India has a gigantic stash of information because all of the cash re-denomination has to pass through the banking system. Mr. Modi’s re-hiring of more than 60,000 recently retired income tax employees shows the emphasis on monetizing the data. Every day brings stories of high ranking officials in the government and banks that are under investigation for trying to launder large sums of money. This feels like a completely different from a time when most of the high and mighty were mostly immune.

Making uncertainty work for you. Having seen such a dramatic move, there is no certainty that more measures aren’t in store. The government has already hinted that so called ‘benami‘ assets (colloquial for assets where ownership is hard to establish, usually assets held in the names of others by those who want to hide their holdings) are next. As we argue later, even the R 2000 bill could be withdrawn after the election. The uncertainty is enough to reduce the hoarding of cash, helping push the demonetization process.

If the shock is reversing, does the RBI really need to cut? Yes, because there are permanent effects and a reallocation of resources to consider. As we explain above, there is some permanence and persistence involved. The shock to undeclared or illegal economic activity is a shock to the macro economy whether we like it or not. The loss of economic momentum in those areas imply that the RBI has to incentivise economic activity elsewhere, and rate cuts are the perfect tool.

Are rising oil prices and a strong US dollar a concern? Rising oil prices are a stag-flationary concern for India but core inflation that has already fallen combined with this disinflationary shock should (rightly) keep the RBI from worrying too much about inflation at the moment. India is already one of the rare economies in EM whose exposure to rising rates and a stronger US dollar is limited – see our note on EM exposure.

So why haven’t they cut? We were surprised they didn’t cut in December. The new Governor may be keen to ensure that the end of Mr. Rajan’s conservative term does not cast him as someone who is just the opposite. Regardless, he should, and will, cut rates. February’s meeting is too far, making an intermeeting likely.


A Political Monetization China’s political consolidation was hidden in the anti-corruption Trojan Horse. It is sometimes hard to tell whether the main objective of China’s historic anti-corruption campaign is to eliminate “tigers and flies alike” in the fight against corruption, or a mix of McCarthyism and a Stalinist political purge that will see more tiger kills than fly-swatters. Mr. Xi Jinping is undoubtedly stronger after 4 years of this campaign, but no one knows when it will end or strike next. While the massive kleptocracy that China suffered in the past justifies the ongoing anti-corruption drive, such a long period of uncertainty has eventually taken its toll.

Mr. Modi’s campaign has, surprisingly, done better. His singular but transparent policy strike has almost certainly crushed his political opposition by tackling illegal funds that most suspect for good reason are parked with politicians and property developers (traditional allies of the Congress party). But this bold action has also captured the attention of policy-makers the world over because it has put into practice what the advanced economies have been debating – abolishing high denomination notes to make money-laundering harder.

There has certainly been pain, but this policy change has seen much more public support than might be expected in these populist times. An election date of 2019 leaves plenty of time for the electorate to be wooed by the benefits of this change, and Mr. Gandhi’s efforts as the leader of the opposition to mobilize public opinion against Mr. Modi have thus far fallen embarrassingly short.

A Policy-Mix Monetization – A bigger fiscal share of the pie and monetary support for the size of the pieFiscal revenues will take up a bigger share of the pie as transactions become more transparent. But does the size of the pie remain the same? Unfortunately, no. Even though we may not like it, sectors like property development that had undeclared cash revenues will no longer be as active because they won’t receive the same implicit ‘subsidy’. If nothing is done, property construction will become less attractive and lead to a lower level of economic activity, i.e., a smaller pie. To keep the size of the pie steady, the RBI will cut rates to incentivize other promising sectors of the economy towards greater participation and profitability.

The result? Smaller fiscal deficits, lower inflation due to a positive supply shock from the erosion of the corruption tax, and lower real interest rates through better allocation of resources.

Monetizing the Market Opportunity – Liquidity shock reversing, Solvency better after more pain. Thepain for retail businesses is waning. Business is not as usual yet because cash transactions are still constrained, but the worst is well behind us. The property sector and perhaps public banks that lent for such activities (given the historical support that the Congress party has had for property developers) need to be looked at very carefully and on an individual basis. An obvious win is going to be the rise of electronic transactions services that have both a tax-cut and the blessings of the government.

So the worst of the shock to the retail sector is behind us, the RBI is likely to cut rates to fight the permanent/persistent component of the shock, and India’s resource allocation is likely to get better. Sure there are risks, but there is quite a bit in the price already. To us, this seems to be a clear opportunity to be pursued.


The only part that is a mystery is the R 2000 note – why was it introduced? So you take away the 500 and 1000 rupee notes and then introduce a new 500 and a 2000 rupee note when your long-term objective is to reduce money stockpiling and hurt corruption? The only we this makes sense if the 2000 rupee note too is be withdrawn (after the election). That keeps matters uncertain enough that most will be reluctant to hoard it, and those who do hoard it (so the administration will say) were warned adequately (and it would be right).

Targeted anti-corruption measures, countered by fiscal and monetary relief are likely Further anti-corruption measures are almost guaranteed, but they will be targeted like China’s measures and on a much smaller case. Mr. Modi has already announced fiscal relief to farmers, low value-home buyers, and the elderly – more of such measures are likely too. A large move similar to November’s is unlikely before the elections.

There are some downside risks too, but they don’t dominate our outlook at the moment. The demand shock could have much more persistence as the hit to the property sector flays both developers and the banks that funded them. As the election draws near, there is a risk that more populist measures to come – though Mr. Modi has hopefully learned his lessons from pursuing a failed populist strategy in one of the biggest state elections a year ago that his party lost soundly.

Bottom line, this has been a stress test like no other and a better economy will follow. Better resource allocation and administrative efficiency will follow. Mr. Modi (or anyone for that matter) will not eliminate corruption or tax evasion, but this is a gigantic step in the right direction.

All in all, it’s a sizeable brick in the wall.

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