November 2016: Demonetisation – short term pain, long term gain

There is no date better marked in recent Indian economic history as 8th November, 2016 – 8pm to be precise – when PM Modi addressed the nation to announce that 500 and 1000 rupee notes would cease to be legal tender from midnight, except for limited purposes. The number that is being tossed around is the 15 lakh crores ($220bn) in these high denomination notes that are outstanding and that they constitute 86% of the total currency in circulation. For at least a few days the whole nation came to a screeching halt as everyone got into queues to deposit, withdraw or exchange their high denomination notes. It is to be noted here that a demonetisation of this scale (in terms of proportion of total currency outstanding) has not been tried anywhere else before – so, a lot of the analysis may be intelligent guesswork at best.

There is no doubt that this measure has resulted in considerable pain for a large number of people, especially those for whom the dominant mode of transaction is cash. People who have suffered, have included daily wage workers, farmers and also small and medium enterprises (SMEs) many of whom, have requirements for cash as a dominant means of transactions. While the opposition has taken the government to task for not being adequately prepared before introducing this measure, the government says that this was a result of the need to maintain secrecy in order for the measure to be effective.

While there is short term pain for many, we expect that there will be considerable long term gain as a result of this measure, and this measure would have to be followed by other measures to combat the black economy. Demonetisation and the war on black money ties in very well with the implementation of GST which has crossed the legal hurdle in terms of the constitutional amendment having been passed by both the houses of parliament, ratified by more than 50% of the states and assented by the President.

These measures by the government are expected to widen the tax base both for direct and indirect taxes. As more and more people realise that their unaccounted wealth is less productive because it sits idle and is also at the risk of being impounded, more people will come into the tax net. With GST everyone effectively polices each other as each producer takes credit of GST for the inputs that s/he pays for. Whether the SME (manufacturing products or selling services) sees the benefit in coming into the tax net, given its cost structure including compliance cost, is still up for debate, but one expects tax compliance to increase over time, as the government is likely to bring more such measures to combat the unofficial or black economy.

One would also expect inflation to trend downwards in a sustainable manner because of these measures. An increase in the tax/GDP ratio can be expected from these measures which should translate into lower fiscal deficits, consequent less crowding out of the private sector and sustainably low inflation over the long term. This in turn should lead to sustainably lower interest rates. The improving tax collections would also permit the government to spend on infrastructure and social sectors.

However demonetisation will not come without its collateral damage. The damage to GDP is already being felt by many businesses, with the damage being greatest wherever the cash element of transactions is higher. These include agriculture, SMEs and logistics among others. The biggest impact could be on real estate prices. Anecdotally one hears of a 20-30% price erosion in land which is located outside city limits – a clearer picture would emerge over the coming months. Traditionally there has been a certain cash component to many land transactions, and a curtailment of the black economy would likely have an impact on real estate prices. How large an impact this could be, is difficult to ascertain, given the many moving parts in this equation. This could in turn have an impact on bank NPAs in terms of their Loan against Property portfolios as also because a large proportion of business loans have land/property as collateral. Should there be a large decline in land prices, although it will be beneficial to genuine buyers of property, it could have a dampening impact on business sentiment.

What one also foresees is that demonetisation along with GST will tilt the balance of trade in favour of the organised sector vis-a-vis their unorganised competition. In effect, the organised sector which pays taxes, will find its position strengthened against unorganised competitors, many of whom could have been using tax avoidance as a low cost edge. As a result, one expects the organised sector to gain market share over their unorganised counterparts. The companies listed on the exchanges are largely more tax compliant and part of the ‘organised’ sector and hence should benefit over the long term.

Having administered a severe shock to the citizenry in terms of demonetisation, we expect the government to lower income tax rates in the upcoming budget in line with the original promise made in the first budget speech of this government. This would not only work as balm, but would also provide an incentive to people to embrace the tax paying economy wholeheartedly. A leader who can take such a massive gamble, is unlikely to stop here. More measures will likely be announced over time, and some of this may once again target the property sector since a lot of the untaxed income is stored here.

Recently, the government has introduced an Amendment Bill to the Income Tax Act in the Lok Sabha. As per this bill a person can voluntarily declare his hitherto undisclosed income at a ‘net tax plus penalty’ of 50%, and additionally 25% of the amount declared to be placed in a non-interest paying deposit for 4 years. This translates into a roughly 55-56% effective tax on income. We think that many people may adopt this method to convert their black money and come into the tax net – this would be a win-win for everybody as these people are likely to be more confident consumers as well as investors.

In sum, demonetisation is likely to have large long term gains for the Indian economy, particularly because of its linkages with GST and higher tax compliance. However, there has already been and may continue to be for a few months, substantial pain for some sectors of the economy as also the citizenry. However, we believe that the patient should take this bitter medicine in the hope of a brighter future. While our portfolios have also taken a hit because of the shock to the market, most of our portfolio companies are high tax paying and would benefit from the expected lowering of corporate tax rates. Moreover, many are leaders in their respective businesses and should benefit from the market share shift to the organised sector.