Demonetization of currency (1)

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DemonetisationAssessment of Macro & Sectoral Impact

November 2016

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Index

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Macro Impact 3

Sectoral Impact9

Financials Real Estate Oil & Gas Consumption Infra Hospitality Auto Others

Macro Impact

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Brief Background on the 2016 Demonetisation Announcement…

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The government on 8th November announced that INR500 and INR1000 notes will cease tobe legal tender immediately

The move is aimed at controllingblack-money, fake currency circulation and terror financing

India has amongst the highest levels of currencies in circulation at 13% of GDP (vs. EM average of 4%)

Some important numbers to bear in mind:

Notes in circulation as of Nov 4, 2016: Rs. 17,742 bn (13% of GDP)

Value of 500/1000 notes in circulation (@86.5% of notes in circulation): Rs.15,347 bn (11% of GDP)

India has carried out demonetisation exercises twice before, in 1946 and 1978

In the Jan-1978 episode, currency worth INR1.46bn (1.7% of total notes in circulation)was demonetised. Of this INR1.0bn (or 68%) was tendered back

The impact of the demonetisation exercise was as follows:

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India’s Past Experience with Demonetisation…

Variable ImpactDeposit Growth Rose sharplyCurrency in Circulation Moderated sharplySLR securities Sharp increase in investment in government securities by banks

Credit Growth Initially subdued but started picking up after 4 months (by May 1978)GDP Growth No major impact as high-denomination notes which were cancelled

only accounted for 0.1% of GDP

In 1978 the value of demonetisation was very small (only 0.1% of GDP). However, the 2016 demonetisation efforts covers 86% of the total currency in circulation (11% of GDP). Hence, this is a substantially more widespread exercise which will have far reaching implications

Impact on Macro Variables in the near-term (3-6 months)…

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Variable Impact (3-6 months)

Comments

GDP Negative

In the near-term, this move will hurt economic activity across sectors with pronounced slowdown across sectors irrespective of the extent of usage of cash. Risk aversion is likely to inch up manifold. Over the next 6 months, most sectors (exceptIT & Pharma) will face growth challenges, and in particular hurt discretionary spends, gold and real estate purchases.

Inflation PositiveDownward pressure on prices due to lower demand, especially in rural areas whereshare of cash transactions is high

Liquidity & Rates Positive

Improved liquidity in the banking system will be positive for lending rate cuts. The possibility of 50bps of rate cut by the RBI has also opened up if demand slowdown becomes severe. This should further support decline in G-sec yields (10 year G-sec yield has already declined 30bps)

Current Account Deficit (CAD)

Neutral to Slightly Positive

Discretionary consumption slowdown is likely to impact non-oil non-gold imports. After the initial surge in gold demand (as cash is converted to gold), gold imports should also start to slow. Thus, the decline in imports should be positive for CAD

Fiscal Deficit Negative

Most of the gains (higher direct tax collections and RBI surplus if any) will accrue inFY18. On the other hand, indirect tax collections is likely to be impacted in the near- term due to demand slowdown. Thus, there is going to be near-term pressure on government finances

The RBI balance sheet as of Nov 4th is given below:

To understand the impact on RBI’s balance sheet, we first put out some numbers and assumptions: Value of notes in circulation as of Nov 4, 2016: Rs. 17,742 bn Value of 500/1000 notes in circulation (@86.5% of notes in circulation): Rs.15,347 bn Assuming 20% of the 500/1,000 notes are not tendered back (“black money”): Rs.3,069

bn Amount flowing back to banking system after demonetization: Rs.12,277 bn Durable deposits (assuming 20% of the money deposited in banks is not withdrawn as

cash):Rs.2,455 bn

Impact on RBI’s Balance Sheet and its Implications…(1/3)

Liabilities Rs. Bn Assets Rs. BnNotes in Circulation 17,742 Foreign Currency Assets 23,156Deposits 5,743 Gold Coin & Bullion 1,368- Govt. 1 Govt. Securities 7,562- Scheduled Commercial Banks 4,095 Loans & Advances 468- Others 1,647 - Govt. 43

Other Liabilities 9,217 - Scheduled Commercial Banks 371- Others 54

Other Assets 147Total 32,702 32,702

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The impact on RBI’s balance sheet is likely to be as follows: We have assumed ~Rs. 3 trillion will disappear from the system. So currency in circulation will

come down by the same amount We have also assumed that the remaining Rs.12 trillion will get deposited with banks. However,

of this 80% will be eventually withdrawn while 20% will remain with the banks as deposits Thus currency in circulation will further come down by Rs.2.4 trillion (80% of Rs.12 trillion) Thus, total decline in currency in circulation = Rs.3 Trillion + Rs.2.4 Trillion = Rs. 5.4 Trillion Banks will get durable deposits of Rs.2.4 Trillion (20% of Rs. 12 Trillion). Thus, Scheduled

Commercial Bank deposits with the RBI will increase by Rs.2.4 Trillion Thus, the net effect is that RBI’s liabilities will decline by Rs. 3 Trillion

New RBI Balance Sheet

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Liabilities Rs. Bn Assets Rs. BnNotes in Circulation 12,218 Foreign Currency Assets 23,156Deposits 8,198 Gold Coin & Bullion 1,368- Govt. 1 Govt. Securities 7,562- Scheduled Commercial Banks 6,550 Loans & Advances 468- Others 1,647 - Govt. 43

Other Liabilities 9,217 - Scheduled Commercial Banks 371- Others 54

Other Assets 147

Total 29,633 32,702

We know that RBI’s liabilities will decline by Rs.3 trillion. Now two options are available to theRBI to ensure that assets match liabilities:

Option 1: The RBI gives Rs. 3 trillion to the Govt. as “special dividend”. In this case, Govt. deposits with the RBI increases by that amount and thus total RBI liabilities match total assets

Option 2: RBI cancels old debt of government on its balance (its assets decline by Rs.3 trillion) or creates a contingency reserve (its liabilities increase by Rs.3 trillion)

If Option 1 plays out, then the drag on growth is likely to be short-lived and we are likely to seen a sharp rebound in economic activity in FY18 as govt. is likely to undertake significant fiscal stimulus

If Option 2 plays out, then the drag on growth could extendbeyond two quarters

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The only answer that will determine whether growth (after the initial slowdown) can see a sharp rebound in FY18 is: Will the Government get large windfall gains to undertake fiscal stimulus?

As per Ex-Governor Rangarajan, the profits that are made by the RBI are essentially out of the current transactions

There is “no capital gain or capital loss” as far as the RBI is concerned. Therefore there is no scope for any extra dividend to be declared to the Government. The RBI act has to go through amendments to make it possible

Globally also, in the past demonetisation episodes, Central Banks have chosen to reduce the asset side of their B/S. Thus, there is little precedence of windfall gains accruing to the Government

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Can a “Special Dividend” be provided to the government?

Growth subdued but domestic liquidity bazooka to banks……

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While the demonetisation exercise is growth negative, a major positive is the improvement in domestic banking system liquidity

The improvement in domestic liquidity conditions is visible in the following:

Indian govt. bond market has rallied sharply since Trump’s victory in sharp contrast to the negative bond action seen globally (36bps decline in 10-year G-sec so far)

Money market rates (3M and 12M CP rates) have also declined by 50bps

Banks have cut MCLR rate by 20bps

With RBI looking increasingly likely to cut policy rate, lending rates should come downfurther

Thus, the next couple of months appears to be a good time for Corporates to raise money

Demonetisation Impact on relevant sectors

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Demonetisation - Sectoral Impact – Summary

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Sector Medium Term Impact

Financials - Banks Marginally Positive

Financials – NBFCs Mixed – Divergent across Segments

Real Estate Negative

Oil & Gas Neutral

Consumption – Staples Neutral

Consumption – Discretionary Negative

Infrastructure Slightly Negative

Hospitality Negative

Autos & Auto Ancillaries Negative

Others Divergent across Segments

Demonetisation Impact

Sector Impact Comments

Banks Marginally Positive

Increased share of savings moving to banks; high CASA ratio (lower cost of funds)

Lower bond yields resulting in high treasury gains (particularly PSU banks)

However, negative from credit growth perspective and asset quality

challenges (banks with high SME exposure)

NBFCsDivergent

impact on sub-sectors

Housing Finance: Negative: LAP/developer loans may see increaseddelinquencies ; underlying demand slowdown to affect credit growth

Auto Finance: Negative: ~60-70% transactionsare done in cash; resale values likely to come down for vehicles; Asset quality issues to worsen

Gold Finance: Positive in medium term – Near term disbursements to get hit as high cash dealing; However, ~75% of gold lending is from unorganized segment which will gradually shift to organized players

Micro finance: Positive in medium term – ~70% transactionsdone incash; Near term disbursements/collections to get hit; However,

positive in medium to long term as borrowers shift to bank accounts

Financials Oil & Gas HospitalityInfraConsumption AutoReal Estate Others

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Views compiled from Jefferies, CLSA, CSFB, CRISIL, ICRA & management interactions



Real Estate Negative

Very negative for residential space, land deals. Limited impact on commercial transactions, hospitality or retail

Greater impact on small builders, and in specific cities / (Tier 2/3 cities, NCR etc.) / micro markets where cash dealing was more prevalent. Resale properties impacted more than primary sales.

Organized builders may also face demand slowdown in near term. Another view is, if supply of resale properties declines due to price crash, it may favourably impact primary sales.

Registered prices in residentialmay go up to adjust for cash component Execution of ongoing projects will be affected, and some developers

may face serious fund crunch Positive in long term: De-monetisation coupled with Real Estate

Regulation Act, Benami Act and GST, will transform RE sector in longer term. Key positives expected - increased transparency, improved investor confidence, better access to funding, higher FDI likely.


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Consensus views compiled from Real Estate consultants - Knight Frank and JLL; analysts – Jefferies, Edelweiss; rating agencies – Crisil, Fitch



a) Petroleum &petroleum products Slightly negative

Temporary pick up in demand due to significant pre-buying of auto fuels

Over medium term, demand, especially for personal transportationcould be somewhat negatively impacted due to high proportion of cash transactions

b) Citi Gas Neutral Largely unimpacted, the demand for CNG might get slightly hurt where cash transactions are high


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Views compiled from Edelweiss & Jefferies



a) Consumer Staples Neutral

Given the need based demand and small purchase tickets, the impact on demand would be muted

However, the move should benefit organized retail and hamper

the market for local counterfeit goods

b) Consumer Durables Slightly negative

Sales likely to be hampered over short-term, especially sales through unorganized channelsas cash purchases (~70-75% of the overall sales) take a hit

However sales through online retail should pick up relatively

c) Consumer Discretionary Negative

The adverse wealth effect will likely hurt higher end discretionary demand.

At the same time lower rates should provide a buffer in the medium term

d) Liqour Slightly negative Most of the purchases by retailers are through cash which may bring down volume in the near term


Views compiled from Edelweiss, Jefferies & CrisilConfidential 18



a) EPC/ Construction Neutral

Most of these projects have big ticket sizes and revenue is from larger corporate housesand government authorities, which do bank transaction

However, for small contractors, due to cash crunch there will be some disruptionin medium term

Toll collection, which are mainly done in cash, may see some hiccups in short-term

b) Building Material

(Cement , Paint , Tiles etc.)

Negative

Likely to be negatively impacted as the underlying real estatedemand (~60-65% of consumption) will be severely impacted due to curtailment of black money

Large part of transactions done in cash in segments like paints,

hence likely to be negatively impacted


Views compiled from Edelweiss, Jefferies & CrisilConfidential 19



Hotels Negative

Demand to be impacted due to slowdown in Domestic Travel

Near Term Impact on Corporate Travel whereas Inbound demandto remain unaffected

Tour Operators Negative

Domestic Leisure Travel: Severely impacted as majority of spending is in cash

Corporate Travel: There maybe temporary slowdown in corporate travel due to cash crunch

Inbound: Inbound travel to remain unaffected Outbound: Outbound travel through unorganized

players impacted as foreign exchange usage abroad is

mostly in cash


Views compiled from Edelweiss & management interactions (Cox & Kings)

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Autos & AutoAncillaries Negative

Two Wheelers: High impact on 2 wheeler sales as large % of rural 2W transactions are in cash, % transactions backed by loans is lower

Passenger Vehicles: Short term impact due to purchase deferment; demand will revive in medium term.

Luxury cars & SUV: Sales will see significant impact due to wealth deterioration and decline in rural transactions (cash based)

Commercial Vehicles: Negatively impacted. 2nd hand truck sales, which had higher % of cash transactions, will decline sharply (both number of transactions and pricing)

Tractors: Demand to be materially impacted; plus questionable trade practices like over-invoicing to moderate


Consensus views compiled from analysts - Jefferies, Edelweiss; rating agencies - Crisil and FitchConfidential 21



Media – Cable TV Negative

Elongated working capital cycles for Multi System Operators (MSOs) due to cash dealings of Local cable operators (LCOs)

ARPU growth may be delayed and Bad debts may increase due to payment delays by LCOs

Media – Print media Negative

Slowdown in real estate (major advertiser in regional print) will impact ad revenue growth for Print media

Metals Negative

Demand slowdown from end consumers such as auto, white goods and construction(residential) is likely to result in lower domestic volumes.

Pressure on debt servicing for leverage metal companies due to drop in volumes


Views compiled from Edelweiss & Ambit CapitalConfidential 22

Economy & Finance

Demonetization of currency (1)