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Effect of Demonetization in Banking Sector: A Game of Pros and Cons

Avatar Written by Srijani Chaudhuri

At the sundown of November 8, 2016, the Prime Minister of India, Mr. Narendra Modi surprised the country by declaring that the INR 500 and INR 1000 will no longer be a legal tender from midnight. The RBI termed it as a ‘bold’ move in the battle against corruption and black money. New chip based INR 500 and INR 2000 notes were to be circulated by November 10, 2016. Controversy, opinion, debate flooded regarding the policy. According to the Ministry of Finance, during 2011-2016, the growth of circulation of all notes was 40% whereas the circulation of the targeted denominations went up by 109%, which is a contradictory number and hence the sudden policy imposition.

Well, this move will definitely eliminate the prevailing stock of fake currency to quite an extent in the long-run, but, its impact and repercussions will resonate across sectors with varying concentrations.  This blog concentrates on the impact of demonetization on banking sector. Is the policy turning out to be positive or negative for the banks?

As an instantaneous response to the policy, the banks observed extended queues were panic- stricken citizens flocked to deposit INR 500 and INR 1000 notes in exchange for lower denomination. The queues were observed in every bank branches, across the country. Though commercial banks had predicted the rush and prepared their outlets with enough cash and longer working hours, however it created uneasiness among people who figured out that the whole procedure demanded long wait along with unavailability of new notes.

On a brighter side, this ‘rush’ is an indicator to growing currency deposit in Current Accounts and Savings Account (CASA) of commercial banks. This will further improve the liquidity locus of the banks, which can be exploited later on for lending purposes. The improved CASA will automatically diminish the dependency of banks on high cost borrowing. Let us assume around INR 15 trillion of the targated currencies are in circulation in the market, of which 50% gets deposited. This will add to the CASA deposit by INR 7.5 trillion. This count is 9 % of the deposit base. In such a situation, banks will lower the funding cost and transfer the benefits as lending rate cuts.  Therefore, CASA improvement will remain positive for short run and long run. This is majorly due to upsurge in money multiplier in the country and increased deposit multiplier for banks.

As per the SBI Chairman Arundhati Bhattacharya, “All rates will fall. The bank has seen huge inflow of deposits but demand for credit has slowed down. Therefore, lending rates too will fall but after a gap.

Keeping the statement in mind, with ample liquid funds, banks will cut down their deposit rates. Already ICICI, Canara, HDFC Bank have slashed their fixed deposit rates by 1%. Similarly, State Bank of India has slashed their fixed deposit interest rates by 0.15%. In such a scenario, this will automatically lead to a cut in the lending rates. Thus, this calls for a lower EMI in future.

On the contrary, these reduced fixed deposit rates will create a strong competitor for the banks, which is the market for mutual funds. People will prefer to keep their money in mutual funds to receive more returns. Quite a number of mutual funds have given 2% return over the week. With stock prices crashing due to demonetization, there is a high possibility that citizens will invest in equity mutual funds at a lower rate and reap its profit in the long run.

Now, the condition for Non-Performing Assets (NPA) in banks will get hit the most. As an immediate outcome, sectors with high cash flow will be much affected, this includes the real estate and unorganized service sector.  With the dearth of liquidity in these sectors, NPA and working capital credit is to shoot up drastically.  Agriculture loan will also contribute to NPA. However, the extent to which the ongoing NPAs will be covered is worth watching out for.

The Effects, Three Years On

It has been three years since India decided to demonetize a large part of its currency in circulation. What have been the long term effects of the move?

Some alternate modes of payments have risen. Mobile wallets and instant transactions have picked up. However, cash has also made a come back. It is hard to fathom whether the move to digital is a consequence of the cash crunch or part of the larger trend.

The unorganized sector plays a large role in India’s economy too. Needless to say, some types of growth stuttered for a while as cash was sucked out of the system. Today, India’s economy is at risk of stagnation. Again, it is hard to draw a clear line from demonetization to today’s economic situation. It is, however, one among many causes.

Why Does It Matter to Global Companies Sourcing from India

Major economic moves from the government and its regulators can impact companies who operate in or source from that country. The impact can be one of risk or opportunity. Significant moves like demonetization must be evaluated by procurement and risk leaders to predict, and plan for, potential impact.

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