Demonetization Effect on Stock Market

 

Demonetization Effect on Stock Market

After November 8, 2016, the word ‘demonetization’ became a household word. In a daring, unexpected and completely baffling move, PM Narendra Modi announced on November 8, at 8:00 PM that existing high value currency notes of INR 500 and INR 1,000 will no longer be currency notes. They will be just pieces of paper with no value whatsoever.

Demonetization Effect on Stock Market

But, what is demonetization?

Whenever a particular currency note stops being a legal tender, it is known as demonetization. This means, in the current scenario, two things happened:

  • Currency note of denomination 500 is just phased out because new design has been circulated.
  • Currency note of denomination 1000 has been demonetized because that particular denomination will no longer exist. Instead, Government of India has circulated a higher denomination note of INR 2000.

Is it first demonetization in India?

This isn’t the only demonetization India has experienced. In the past, demonetization took place twice. The table below will give a quick overview of the same:

Year of demonetization Currency notes demonetized
1946 INR 1,000 and INR 10,000
1978 INR 1,000, INR 5,000 and INR 10,000
2016 INR 500 and INR 1,000

Reasons for recent demonetization

Now, one of the biggest question is, ‘why did the recent demonetization take place?’

This recent demonetization had multiple motives behind it. These motives include:

  • Clampdown on black money and making Indian economy free of black money in future.
  • Uprooting corruption from Indian economy and making a corruption-free India.
  • Driving India into becoming a cash-free economy in near future which will prevent rebirth of black money and corruption.
  • Ending counterfeit money which supports terrorism and hence, effectively paralysing cross-border terrorism.

Effect of demonetization on Indian Stock Market

While the debate is getting stronger and stronger by the day on the issue whether demonetization was a success or a failure, one of the most important questions that popped out was, ‘what was the effect of demonetization on Indian stock market?”

To be honest, the objectives of demonetization are more or less long-term. We still support it because we needed to start somewhere. However, what’s disturbing is that demonetization gave pain to millions of Indians who are struggling with cash shortage.

With this recent demonetization 86% of cash in circulation suddenly was destroyed. This led to short term pain for people. Banks were struggling to deal with long queues of people trying to exchange their old high-value currency notes with newly circulated currency notes. ATMs remained closed. However, it is not really easy to understand the total economic impact because of this unexpected policy simply by looking at people and banks and ATMs. A more reliable indicator of economic impact has always been the stock market trends.

It is a traditional practice to look at the indices of the stock market to understand the overall economic environment. Persistent and sharp plunges in such indices always indicate that economic activities are deteriorating.

So, did demonetization make any impact?

Basically, stock market is considered to be an independent animal and some policy changes barely impact the indices in the market. However, post demonetization, the scenario was quite different in the stock market.

Just a week after demonetization, the NSE S&P CNX Nifty (currently known as NSE Nifty 50) registered a 5.1% drop in daily closing price as opposed to what was there on November 8 (the day when demonetization was announced). That was the worst close ever since February, 2016.

In case you didn’t know, the Nifty 50 is made up of stocks from companies belonging to various industries. But the pressing concern here is, ‘is there a negative sentiment spreading across all sectors?

It is pretty depressing and heart breaking to say that yes, the data from NSE or National Stock Exchange indeed shows a negative sentiment across various sectors. It turns out that the worst hit sectors have been realty, consumer and automobile.

The table given below shows the differences in price movements for two different periods – before demonetization and after demonetization. Here are some particulars of the table that you should know before going through the same:

  • Several indices of National Stock Exchange have been used. These indices include FMCG, Automobile, Consumption, Banking, Realty etc.
  • The data comprises of prices for 25 days of trading before demonetization.
  • The data also comprises of prices for 11 days of trading after demonetization.
Sectors or NSE Indices Returns in %age before demonetization Returns in %age after demonetization Differences in returns (calculated as percentage)
Nifty PSE Bank – 0.1 0.14 0.24 **
Nifty Private Bank 0.01 – 0.73 – 0.74 **
Nifty Bank – 0.01 – 0.5 – 0.49 *
Nifty Metal 0.2 – 0.14 – 0.34
Nifty Realty – 0.2 – 1.01 – 0.81 **
Nifty Auto – 0.08 – 1.2 – 1.12 **
Nifty India Consumption – 0.1 – 0.93 – 0.83 **
Nifty FMCG 0.03 – 0.82 – 0.90 ***

 

IMPORTANT
* Denotes statistical significance at 10 %
** Denotes statistical significance at 5 %
*** Denotes statistical significance at 1 %
Returns Returns are calculated as mean returns and represented as percentage

The table above clearly shows that the worst hit sectors in India after demonetization have been:

  • Auto
  • FMCG
  • Consumer
  • Realty

If you swing your eyes to the banking sectors, you will notice that the impact is differential. This differential impact may require some explanation. So, let us start with the banking sector.

Demonetization and banking sector

If you try to find out the difference between average return of the banking sector in pre and post demonetization scenarios, you will see that post demonetization returns have been less than that of pre demonetization by 0.49%.

Does that indicate that demonetization has hit Indian banking sector negatively?

Before answering this question, here are two more questions and their quick answers:

  • Did deposits increase in banking sector? Yes, they did and there has been a higher deposit flow into both the savings and current accounts.
  • Any positive impacts? Yes, interest rates have gone down, which will lead to treasury gains and stimulate liquidity.

Now, looking at average returns, did demonetization negatively impact banking sector in India?

This is where we need segregation. Indian banks can be divided into Public Sector Banks and Private Sector Banks.

Public Sector Banks:

These banks have higher average return after demonetization. The post demonetization returns for public sector banks increased by 0.24% as compared to pre-demonetization period. The reasons for this are:

  • 80% of Jan Dhan Yojana accounts are with Public Sector Banks. This means more money in form of demonetized currency notes have flowed into these banks.
  • Government backing is present for these banks. The budget constraints on these banks are soft. They get financial help from government when times become adverse.
  • Public banks have 1/4th the profitability of private banks.
  • The spill over effect from other sectors are usually absorbed by the government, providing enough cushion for the Public Sector Banks.

Private Sector Banks:

Private sector banks did take a hit. The returns dropped. The average return after demonetization for private banks dropped by around 0.74%. But why?

Here are the reasons:

  • Private banks do not have government backing and hence, not cushioned against hard times like this.
  • Different sectors in India are intertwined. This means the negative impact on other sectors spilled over to the private banks.
  • Private banks have only 20% of the Jan Dhan Accounts. This means that the inflow of demonetized cash was very less in these banks compared to that in the public sector banks.

If you compare the two sectors of banking industry, you will see that the gain in public sector is not enough to offset the loss in the public sector.

Demonetization and automobile sector

If you have noticed properly, the automobile sector has taken the biggest hit. The returns after demonetization have dipped down by 1.12%. This is a massive plunge. But what caused it?

In case you did not know, the government actually made it mandatory to disclose PAN details while making auto purchase except for purchase of two-wheelers.

Also, the luxury car segment has always been an area where unaccounted money had been spent in big amounts. People used to purchase those cars using cash. Now, with PAN disclosure becoming mandatory, this segment took a massive hit.

Talking of two wheelers, people can buy that using cash and PAN disclosure is not mandatory but, with a large chunk of cash taken out of economy, two wheelers segment also took a massive hit. The whole negative impact shows up through auto index of NSE.

Demonetization and realty sector

This is yet another sector which has taken a massive hit. One of the reasons is that real estate, just like automobile has been a channel for black money or unaccounted money storage. Yet another benefit for the realty sector was that tax system was multi-layered. There is service tax, there is VAT, there is registration charge and then there is stamp duty. Because of all these layers, the sale price has always been way higher than actual document price for properties.

With demonetization, dumping black money or unaccounted money in real estate sector, especially into luxury real estate, high-end real estate and resale real estate is not nearly impossible. This means that the sellers are now under tremendous pressure to sell of the existing properties. You should know that India’s real sector industry was booming and the supply end of the sector ballooned up only recently. With too many properties to sell and cash transactions taking a massive hit, the sellers are now dropping off the prices for offloading the properties. Prices have already dipped down by about 30% for luxury properties.

Good thing about the real estate sector however is that most of the cash that was invested into the sector was actually coming from those investors who hoarded black money. That unaccounted money was invested into the real estate projects with one objective – booking profits by raising prices. With black money taken care of through demonetization, these investors will be wiped out of the market, providing a much-needed price correction. This will open up legal channels of financing properties.

Demonetization and FMCG and Consumption sectors

FMCG is basically a subset of the consumption index of Nifty. The average returns for both have decline after demonetization. These sectors basically reflect behaviour in health care sectors, consumer durables, hotels etc. These sectors have taken a massive hit simply because of the cash shortage. There is a two-pronged impact here:

  1. With shortage of cash in market, the demand has fallen for such goods and services.
  2. Consumers are now in a mood of stashing usable cash and spending as less as possible – that is only on goods and services which are considered as necessity. This is further dropping the demands for premium consumer goods and FMCG products.

Because the consumption sector has taken a hit, the economy as a whole has also taken a hit. Lack of consumer confidence and propensity to hoard useable cash is actually taking a toll as being reflected in the respective indices on Nifty.

Negative effect of demonetization – temporary or permanent?

Try and evaluate the situation on your own. Do you think this negative impact will be permanent or is it just a temporary impact?

Okay, we will tell you what we think and what experts think.

This impact is temporary. This temporary impact is because of the fact that 86% of country’s cash was wiped out overnight and this led to severe cash crunch, forcing people to save usable cash until the Reserve Bank of India pumps in equivalent amount of cash into market.

However, talking of the stock market, the scenario is certainly different. Nifty indices are showing deflationary pressure but with new cash gradually entering the market, the consumer demand is gradually increasing and the market is making an upward correction gradually.

For the current scenario, the market has managed to get a 50% correction in terms of price and in terms of entire movement, a 38% correction has already been registered. Nifty has taken a support at the level of 8,000. From perspective of traders who trade in the short-term, keeping stop loss below 8,000 will allow them ample opportunities for quick rally. For those who eye for long term, this is the right time for portfolio diversification for the long term because prices are low but they will gain soon as the inflationary pressure comes it after enough new currency notes have been injected into the market.

Good thing about the stock market is that it is basically a machine which follows a six-monthly forward discounting. Any event which leads to a negative impact will actually end within one or at the most two quarters. So, the negative impact and the deflation that is showing up because of demonetization of high-value currency notes, will eventually fade off.

Will low growth impact Indian economy?

Only recently, India became one of the fastest growing economies in the world. However, the recent demonetization actually halted that fast run for sure. Will this impact Indian economy adversely? Let us try to answer this question in the best possible manner.

Indian economy is basically cash intensive. From real estate to automobile to FMCG, everything heavily depended on cash. Demonetization took off 86% of cash circulating in the economy. This adversely affected all the cash intensive sectors.

The consumer sector (and its subset FMCG sector) contributes to 56% of Indian GDP. Decline in this sector is definitely going to hit GDP of the nation and slow down the growth because of deferred purchases.

The good part is that the slowdown is temporary. We don’t even have to look into the long term to say this. In the medium term, government spending is going to increase significantly. This will produce direct benefits for the economy.

While government can be looked upon as a macro-economic element, we can always look at the households, which are the micro-economic elements. In case of households, there will be a switch from physical savings to financial savings, which will in turn, help to boost economic growth. Government on the other hand will be able to maintain a proper fiscal discipline.

Conclusion

The negative impact that showed up in stock market after demonetization is gradually rebounding back to normalcy. Over time, the stock market will improve as consumer demand rekindles with injection of new cash.

Even if the government decides to cut down on cash supply significantly and push for cashless economy, situations will improve because government treasury will become plump and government spending will increase.

How can we say that government treasury will improve by going cashless?

Cashless economy will prevent unaccounted money or black money hoarding. With accounted money, government revenue will increase through tax collection. Tax has always been one of the biggest revenue sources for government. This is why government treasury will improve. On top of that, with decline in use of paper notes, millions of rupees will be saved because of reduced costs of paper and ink acquisition as well as reduced printing cost and circulation cost.

Coupled with GST, demonetization and cashless reforms will also improve India’s global ranking in terms of ease of doing business. This will attract new business and FDI (foreign direct investment). FDI is yet another source for government revenue.

The move of demonetization has been bold and there are some short-term negative impacts. However, the medium-term and long term benefits can offset these short-term negative impacts and help India evolve into a corruption-free nation state with greater transparency and public power. What do you think?

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