Demonetization: Can Pandora’s Box Contain Goodies?

The scheme for demonetization of Rs 500 and 1000 notes announced on 8th November, 2016 and aimed at curbing black money (BM) in India has opened the proverbial Pandora’s Box. Apart from stiff opposition from most, if not all, political parties the scheme is also facing tremendous logistical issues. While the level of preparedness of the government leaves a lot to be desired, ultimately the course from here will be determined by ratio of outcome, and inconvenience for the common man.

Here it is important to recognize that large cash in hand, or cash transaction, may not always be black (or bad). The term black money ( BM)refers to money that has been accumulated by corruption or by tax evasion. There is a sizeable proportion of India’s economy that is clean-cash based due to logistical and legacy reasons and that is perfectly legal. Now, before forming views on the scheme and its feasibility it is important to understand what does it intend to do, what does it not target, and what are its limitations.

What does this scheme intend to do

  1. Dampen the purchasing power of people with unaccounted wealth
  2. Cleanse the system of fake currencies
  3. Demolish a key financing element of terrorists and Maoists.

What it is not aimed at

  1. Turn India into a cashless economy

People who can explain the source and trail of their cash should be able to get their cash exchanged from banks in next 4-6 weeks. In fact people who deposit less than Rs 250,000 won’t face any questions. After some inconvenience over next 3-4 months clean-cash based economy too should be able to reach required levels. As an unintended but favorable consequence there will definitely be some move towards increase in cashless transactions in future.

What it may not be able to achieve

  1. Wipe out black money altogether
  2. Eradicate the plague of fake currency forever

What can it achieve

  1. Restore faith of honest citizens that the welfare state has not abandoned its duty to be fair to all its citizens. Here the key is that black money must be made to lose its value.As per this scheme people with large chunk of unaccounted cash have to pay applicable taxes and a hefty penalty. Government will be able to raise a sizeable amount as tax.
  2. Provoke fear of law amongst the dishonest – This event will for a long time weigh in their minds possibly as a deterrent to corrupt activity and tax evasion.
  3. Reduce inflation which can give ammunition to RBI to cut interest rates that in turn may help economic growth by spurring an uptick in credit demand.
  4. Improve liquidity and credit availability in the economy. The hoarded money that had been lying idle so far can now be deployed more productively by banks, or by the people themselves after withdrawing from banks.
  5. Induce trust in the system –As many cash transactions are replaced by cheques, online payment gateways and other modes of non-instantaneous payment, economic agents will need to trust each other more which can over the long term augur well for all economic activities. Perhaps this can turn out to be the biggest advantage to emerge from this exercise.

What are the factors that are prompting opposition to the scheme

  1. This scheme won’t be able to prevent generation of fresh black money – i) True since here the focus is on penalizing those who have been enjoying undue benefits – so far. It is naïve to expect generation of black money to be annihilated in one shot. Had there been a magic wand, governments in the past would have definitely used it. At the same time it is not illogical to demand from the government equally stern measures to control the black money menace in future too. ii) Black money generated in next 2-3 years may only be a fraction of what is being sought to be unearthed by demonetization. iii) In future tax evaders and the corrupt will need to devise new ways to cheat. However the fear induced after this action may provide some deterrence.
  2. Not all notes will be tendered – Yes – A large chunk of the cash may be destroyed by the hoarders but it does not change the outcomes. Either way the dishonest will lose their ill gotten wealth while relative buying power of the honest Indian will be boosted.

Destruction of notes is a sort of poetic justice and at the same time helps in redistribution of wealth away from the corrupt. Notes that are not tendered may add to one time profit of the RBI in practical terms which in turn can be passed on to the government as dividends. Even if RBI does not book this as profit and keeps this amount under the head of other liabilities in its balance sheet it will be owing to conservative accounting. RBI can use it as a large buffer to fight currency fluctuations and liquidity issues later.

  1. This is causing inconvenience to general public – This is the most potent and relevant argument against the scheme. In the first week of the scheme the government has been caught on the wrong foot. Now, the long queues at bank and ATM’s can perhaps be entirely explained by lack of new notes. When almost 85% by value of currency in circulation, ie about Rs 14.5 lakh crore, is sought to be demonetized the level of preparedness should have been much higher to say the least. The government should have been ready with fresh stock of at least 25-30% of the demonetized amount on 8th November. If secrecy was the concern, and rightly so, then a war chest of Rs 100 denomination could have been kept ready.

So far the lure of the outcome (blow to black money) is what has kept emotions of the man on the street from spilling over but situation may worsen if bank queues do not shorten and if cash availability does not improve in next two weeks.

  1. Barking up the wrong tree; Cash as a vehicle to store black money is peanuts as compared to gold and real estate – Even if Rs 2 lakh crore (equivalent to about 35%of India’s fiscal deficit, or about 80% of defense expenditure, or 3 x of India’s education budget) black money is unearthed in this exercise it will be worth the effort.BM in gold and RE can be tackled by other measures in near future.
  2. This did not work in the past – Demonetization schemes in the past were very different from what is being done now since i) In 1978 the quantum of high denomination notes was just about 1.5%of total currency in circulation. In 2016 it is 85%, ii) In 1978 the notes that were demonetized were Rs 1000, 5000 and 10000.Thus demonetization exercise of 1978 was much narrower in its targeting and hence passed off without even a whimper from hoarders of black money.
  3. Reintroduction of Rs 500, 2000 will negate the potential gains –The idea is not to kill the cash economy – even though some shift towards cashless system may happen as collateral gain.Where ever commerce/trade etc are done in cash due to some honest constraints, denominations of Rs 500 and Rs 2000 will be required.
  4. Cost of the exercise is too high – Cost of printing new notes to replace the existing ones can be about Rs 10,000 crore. If seen in proper context (about Rs 80 per Indian, or just about 0.7% of demonetized notes, or equal to fake money stock in circulation) this seems quite reasonable especially in the backdrop of the targeted gains.
  5. People with black money will game the system – Manipulators are trying their best to bypass the government’s dragnet even as the latter remains in hot pursuit. However as of now it does not seem that more than a small proportion of black money can escape detection.
  6. Bad for economy – It is true for short run but in 2-3 quarters the economy should bounce back. Once the gains start kicking in, trade, commerce, agriculture and industrial activities will look much stronger starting 4-5 quarters from now.

In any case, sizeable long term improvements often need disruptive, instead of incremental, initiatives and this is one of the few disruptive efforts seen in India for a long time. It must be given a fair chance.

Perhaps Janet Yellen, US Federal reserve chair, had some such event in mind when she said “Productivity growth, however it occurs, has a disruptive side to it. In the short term most things that contribute to productivity growth are very painful”.


US Elections and Markets:Much Ado About Nothing?

As US presidential elections have come close business news channels and pink newspapers are hysterically discussing scenarios for equity markets. Stock prices have been swinging based on the latest predictions.In fact as Donald Trump has gained in opinion polls in last week or so, Dow Jones in the US has been trending down.

Fear, greed but above all …excitement

We all hate uncertainty and the impending elections are creating fear understandably amongst investors. There will be some who will be waiting for some stock mispricing to appear post the election results so that they can tap the opportunity. Most of us are waiting with bated breath for the outcome. It is quite an obvious question – what should an investor in Indian equity markets do at this juncture?

One way is to take the problem head on. As the first step one needs to figure out how will the policies of the two main candidates Hillary Clinton and Donald Trump affect the markets.This should not be difficult as market strategists and economists have been generously commenting about various scenarios in detail. After that, what is left is to predict who is winning. Here too, agencies conducting opinion polls continue to publish their updated expectations. Finally position the portfolio as per the stated policies of the winning candidate. Simple ! Not really, as we shall see below.

Deep and wide top-down analysis may not always add much value

Selecting sectors and stocks, based on which candidate is wining and what are his/her policy statements does not sound difficult. Additionally it gives one the satisfaction that one is working hard to make money.

However this approach is difficult and futile due to three problems –

a) Forecasting the winner, especially in a seemingly closely fought election is never easy. History is replete with examples where opinion polls have gone horribly wrong – who can forget the opinion polls of Indian general elections in 2004 ?

b) It is not easy to predict the way the new president will act – just on the basis of his pre election claims and promises.It is not easy to guess what is going on in his/her mind.Then, where is the guarantee that the new president will stick to the stance that he/she has publicized so far. In any case over the next four years the president of United States will be fed so much new information that there may be sharp changes in his policy stance in future.
c) Finally, even if we are able to pinpoint the future policies accurately, how are we to predict the company performance and stock performance based on that. Aren’t there other, often more important, drivers behind the performance of a stock ?

Taper tantrums, Daesh, Rexit, Brexit

Let us also take an outside view – how has Indian stock market behaved after some hotly debated political or macroeconomic events in the past.

I) Taper tantrum – In May 2013 when the US fed announced that it was going to reduce its bond buying activity, even after giving ample guidance earlier, the markets – globally as well as in India, had taken a severe beating. BSE Sensex dropped by about 10 % through the coming 4-5 months. However it didn’t take too long for the markets to shrug off the impact of this event. By May,2014 the Sensex was up by 20% versus its May, 2013 levels. For someone with two years investment horizon, at least in hindsight, this event provided a good point to add to his stock positions.

II) Daesh – Early victories of Islamic State in the Middle East in 2H2014 had unnerved many market observers. In fact some commentators had started discussing possibilities of Indian army getting into a face off with IS in near future. The fears turned out to be exaggerated and IS success on the battlefield started fizzling out soon.

III) Rexit – In 1HCY2016 a public debate was raging regarding the need and likelihood of RBI’s then governor Raghuram Rajan getting a second term.There was absolute consensus that Governor Rajan had been doing a great job and a vast majority felt that he must be given an extension.
Most market participants were of the opinion that if he was not given an extension Indian market would nosedive and would see a sharp derating medium term.Media started discussing with amazing regularity,and some respected global newspapers published articles and op-eds highlighting,the potential damage that Raghuram Rajan’s exit would do to India’s image and to investments in India.
In June,2016 the governor dropped a bombshell by announcing that he would not seek a second term and would instead head back to his first love i.e academia. Many market observers, business news anchors and newspaper columnists were dismayed and aired their views highlighting the dent this would make on prospects of Indian equity markets. However in a matter of weeks (or rather, days) it became clear that markets were thinking otherwise. The impact was minimal and short lived.

IV) Brexit – This was another event which had been followed closely by investors in 1HCY2016. Opinion polls, TV interviews and newspaper columns kept people on tenterhooks. Finally when the British voted on 23rd June to exit the EU global, including Indian, markets were hammered for a couple of days.Surprisingly the impact was negated- soon.

Make no mistake, political or macroeconomic economic events do matter for markets.However all headline hogging events may not be so earth shattering as they seem initially.As investors we should avoid forecasting events that are almost impossible to forecast and where no amount of sincere hard work can give us an edge.

Active Inaction:Need of the hour

Now, a word about the type of investment psychology that is required for this. If we have investment horizon of 2-3 years or more, if we are not using borrowed money, and if we are not employing derivatives this inaction may save time and intensify our focus on more important aspects of investment process.

Conscious and well thought out inaction can at times be the best friend of a diligent, hardworking investor with time on his side.Perhaps Blaise Pascal was thinking of investments and markets when he had said “All men’s miseries derive from not being able to sit in a quiet room alone”.