Motilal Oswal Financial Services

21 November 2016

India Strategy

BSE Sensex: 26,150

S&P CNX: 8,074

Estimating economic impact of demonetization

Higher the extinguishment, the more detrimental for FY17 GDP growth



In this note, we present an easy-to-use

model,

which requires making some basic

assumptions to quantify the economic impact of demonetization on banks, reserve

money (M0), broad money supply (M3) and GDP growth. Though banks will witness

huge inflows of deposits initially, they may lose out due to higher withdrawals.



Assuming 10% of the currency in circulation (INR1.8t) does not return to the system,

nominal GDP growth could be 10% in FY17 against our pre-demonetization forecast of

11.5%. The higher the unclaimed currency, the more detrimental it will be for FY17

GDP.



The impact on real GDP growth would depend on how much and how quickly the

inflation metrics get affected. Since prices could prove to be sticky over the near term,

the entire downgrade in nominal GDP growth could be reflected in real GDP growth in

FY17. It implies real GDP growth of 5% YoY in 2HFY17, as against 7.4% YoY in 1HFY17.



To the extent disinflationary forces lead to lower inflation in FY18/FY19, real GDP

growth could witness extra boost.

The Indian government’s recent move to demonetize the high-value currency notes (INR500

Assuming 10% of

the currency in

circulation

(INR1.8t) does not

return to the

system, nominal

GDP growth could

be 10% YoY in

FY17, as against

our pre-

demonetization

expectation (and

market consensus)

of 11.5% YoY

and INR1,000) with temporary restrictions on withdrawals is intended to unearth black

money and punish individuals who fail to come clean about their finances. Although

demonetization is an opportune act, we believe it is also important to measure the economic

impact of such a measure.

‘Short-term pain but long-term gain’ is the broad consensus in the market. However,

since the level of uncertainty is extremely high at this point in time, we do not

intend to make any predictions. In this note, we present an easy-to-use model,

which should help readers to quantify the short-term economic impact (by FY17-

end) of demonetization.

Exhibit 1

below summarizes the impact of demonetization on nominal/real GDP

growth. The impact on GDP growth will be directly linked with the impact on broad

money supply (M3), which in turn is linked with the portion of currency that does

not return to the banking system. Assuming 10% of the currency in circulation

(INR1.8t) does not return to the system, nominal GDP growth, assuming uchanged

forecasts for velocity of money, could be 10% in FY17, as against our pre-

demonetization expectation (and market consensus) of 11.5%. The higher the

amount of extinguished (or unclaimed) currency, the more detrimental it will be for

GDP growth. As our model suggests, if 20% (INR3.6t) of the currency does not return

into the system, nominal GDP growth could be lower at 8.5% in FY17.

Nikhil Gupta

(Nikhil.Gupta@MotilalOswal.com; +91 22 3982 5405)

Investors are advised to refer through important disclosures made at the last page of the Research Report.

21 November 2016

Motilal Oswal research is available on www.motilaloswal.com/Institutional-Equities, Bloomberg, Thomson Reuters, Factset and S&P Capital.

India Strategy

Since the impact on inflation is likely to come with a lag – possibly in FY18 – real GDP

growth could fall by the same extent to 6.2% in FY17, as against our pre-

demonetization expectation of 7.7%. It implies that real GDP growth in 2HFY17

could be

only

5%, as against 7.4% in 1HFY17. As far as the impact in FY18/FY19 is

concerned, assuming things turn to normality, real GDP growth could get some extra

boost due to disinflation.

With lower inflation, real

GDP growth could actually

witness an extra boost from

FY18.

As far as FY18/FY19 are concerned, disinfationary forces may play a signifiacnt role.

Assuming money supply growth returns to normal levels and velocity of money also

turns normal, nominal GDP growth would also return to 11-12% from FY18.

Nevertheless, with lower inflation, real GDP growth could actually witness an extra

boost from FY18.

Exhibit 1: Impact of demonetization on GDP growth in FY17

Unit

FY17#

Unclaimed currency

Nominal GDP growth

Real GDP growth

Real GDP growth in 2HFY17

% of total CIC

INR b

% YoY

n/a

11.1

11.5

7.7

7.9

889

10.3

10.8

6.9

6.5

New FY17 estimates after demonetization

10%

1,777

9.6

10.0

6.2

5.0

15%

2,666

8.8

9.2

5.5

3.6

20%

3,555

8.1

8.5

4.7

2.2

25%

4,443

7.3

7.7

4.0

0.7

30%

5,332

6.5

6.9

3.2

(0.7)

# Our pre-demonetization expectation, Please see inside for details

Source: MoSL

21 November 2016

India Strategy

1978: Only precedent, but not comparable due to size of operation

Demonetization is not new to the Indian economy. This is the third time and the

previous one was almost 38 years ago. The first recorded episode was in 1946.

However, as we do not have any data for pre-independence India, we would discuss

the second episode that happened in 1978. We understand that the size of

operation in 1978 was negligible compared to the current one

(Exhibit 2-3).

However, there are some important points to note.

It may be important to note that demand deposits declined by a record ~30% YoY in

1978

, by far the highest fall in independent India. Notably, the entire decline came

in March 1978 – two months after the demonetization scheme ended

(Exhibit 4).

Nevertheless, neither currency in circulation nor broad money supply measure (M3)

witnessed any contraction for even a single month in 1978 or 1979

(Exhibit 5).

This

was because there was an equivalent surge in time deposits

, due to which total

bank deposits did not witness any significant change. Broadly, there was no change

in bank deposits in 1978. Deposit growth was extremely stable, ranging between

20% and 25% during 1977–1979.

Exhibit 2: Break-up of currency denominations in 1978

1978

INR91b

100, 47%

500, 0% 1,000, 1%

Smaller,

14%

Exhibit 3: Break-up of currency denominations in 2016

2016

INR16,635b

1,000, 38%

100, 9%

50, 5%

20, 8%

10, 20%

50, 11%

Source: Reserve Bank of India (RBI), CEIC, MOSL

Exhibit 4: Significant portion of demand deposits was converted

into time deposits in 1978 (% YoY)

Demand deposits

-20

-40

Demonetization

announcement

Total bank deposits

Source: RBI, CEIC, MOSL

Exhibit 5: …and there was no significant change in currency in

circulation (CIC) broad money supply (% YoY)

Demonetization

announcement

Currency in circulation

500, 47%

Source: RBI, CEIC, MOSL

https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=17177

https://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=7340#6

21 November 2016

India Strategy

We believe our model will

help quantify the economic

impact of demonetization

using different

assumptions.

We understand that the previous episode may not be relevant to the current one

and thus would not delve too much into it. The objective of this note is to share our

model so that readers can gauge the impact of demonetization on GDP growth with

their own assumptions. We believe our model will help quantify the economic

impact of demonetization using different assumptions.

The excel model can be

found here or as attachment in the email.

Please note that the excel models does not incorporate several complications

associated with the recent schemes. To give you some instances, our model is not

equipped to estimate the possible transfer of wealth from rich people to poor

people due to demonetization, which may eventually lead to higher, not lower,

growth (or at least offset a part of negative impact). Further, we have not

integrated the possible adverse impact on the velocity of money, which would

hurt GDP growth. In short, while our model may help get an idea of the impact of

demonetization on various macroeconomic indicators, it misses out on several

pieces of information and is thus not comprehensive in this sense.

Key assumptions to start with…

Like in any model, we start with a few basic assumptions. At the end of this exercise,

one would be able to estimate the impact of demonetization on the following six

key financial/macroeconomic indicators by the end of FY17:

1. Impact on banking deposits

2. Outstanding currency in circulation (CIC) at end-March 2017

3. Reserve money supply (M0)

: CIC + Bankers’ deposits with RBI (CRR deposits) +

Other deposits

4. Broad money supply (M3)

: M0 + Total deposits with commercial banks

5. Nominal GDP growth

6. Real GDP growth

These

assumptions/conclusions do

not reflect our predictions

or forecasts due to the

uncertainty around the

introduced scheme.

Measuring the impact on bank deposits is more complicated than measuring the

impact on GDP. This is because M3, needed for GDP estimation, is unaffected by the

net impact on bank deposits. Further, we need to make many assumptions upfront

to gauge the net impact on banks. Since we are dealing with large numbers, even a

small change in any of these assumptions could significantly alter the conclusion. As

mentioned earlier, these assumptions/conclusions do not reflect our predictions or

forecasts due to the uncertainty around the introduced scheme.

To understand this, we will start with an example making five key assumptions:

1. 50% of the specified bank notes are held as white money.

2. 50% of total black money is declared, while the rest 50% (or 25% of total

currency in circulation in our example) does not come back into the banking

system (or remain undeclared).

3. Average deposit under ‘white money’ category is INR13,000 per person.

4. Average deposit under ‘declared black money’ category is INR2,00,000 per

person.

5. Average withdrawal for next 50 days (till December 31, 2017) from all

depositors is INR400 per person per day.

As of October 2016, assuming 87% of the total currency in circulation (CIC) is in the

specified bank notes (INR500/1,000), there is total of INR15,462b worth of currency

21 November 2016

India Strategy

in circulation in those bank notes. We will try to explain everything in words, but

would encourage readers to refer to the attached

excel sheet for various

calculations and formulas.

Impact on banking deposit – the first step

To measure the impact on CIC and money supply measures, we first need to

understand the impact of demonetization (given above assumptions) on banking

deposits. Although banks have added thousands of billions of rupees to their

outstanding deposits since the move came into effect, it is important to note that

due to the restrictions on withdrawals, the flow of money is broadly one-sided at

the moment. As these restrictions loosen gradually, we believe withdrawals will be

more prominent than deposits. An important point to note is that depositing money

is a one-time activity (precisely what is happening now), while withdrawal is a

recurring process. Therefore, net accretion to banking deposits at end-March 2017

would be different from the initial numbers witnessed in the first few days of the

scheme.

Estimating gross additional deposits to banking system…

Exhibit 6

below helps understand the extent of net accretion to banking deposits by

end-FY17. In our example, INR7,731b is deposited with the banking system under

‘white category’ and INR3,866b under ‘black category’. The remaining INR3,866b

does not come back to the banking system. In other words, 25% of the outstanding

currency turns out to be unclaimed (you may want to look at the attached excel to

see other scenarios). Gross additional deposits to the banking system thus will be

INR11,597b.

Exhibit 6: Estimating impact of demonetization on banking deposits

Total currency in specified notes, INR b (1)

Key assumptions

No of days up to December 31, 2016 (2)

Average withdrawal per day per depositor, INR (3)

Average deposit/person under white money category, INR (4)

Average deposit/person under black money category, INR (5)

Impact on banking deposits

Share of white money*, % (6)

White money, INR b (7) = (1)*(6)/100

Black money, INR b (8) = (1) - (7)

Declared black money, INR b (9) = 50% of (8)

Unclaimed black money, INR b (10) = (9)

No of persons (in b) depositing white money (11) = (7)/(4)

No of persons (in b) depositing black money (12) = (9)/(5)

Total withdrawal from all depositors, INR b (13) = (2)*(3)*(11+12)

Net accretion of deposits on banking system, INR b (14) = (7)+(9)-

(13)

* Assuming 50% of total black money is unclaimed

21 November 2016

1,546

13,916

6,958

0.12

0.03

3,075

5,430

3,092

12,370

6,185

0.24

0.03

5,376

3,901

6,185

9,277

4,639

0.48

0.02

9,979

844

7,731

3,866

0.59

0.02

12,281

(684)

9,277

6,185

3,092

0.71

0.02

14,582

(2,212)

12,370

3,092

1,546

0.95

0.01

19,185

(5,269)

Source: MoSL

400

13,000

2,00,000

15,462

India Strategy

…and then net accretion to banking deposits

Since we assume average deposit per person under ‘white category’ to be

INR13,000, it implies 595 million people under this category (INR7,731b/INR13,000).

Since average withdrawal per person is INR400/day for 50 days, total withdrawal per

person till December 31, 2016 would be INR20,000 (INR400*50). Total withdrawal

from people under ‘white category’ thus would be INR11,894b (595m*INR20,000).

Thus, while ‘white category’ deposits INR7,731b, it withdraws INR11,894b, implying

net withdrawal of INR4,163b from the banking system under this category.

Coming to the second leg of our example, since we assume average deposit per

person under ‘declared black category’ to be INR200,000, it implies 19 million

people under this category (INR3,866b/INR200,000). Since average withdrawal per

person is INR400/day for 50 days, total withdrawal per person till December 31,

2016 would be INR20,000 (INR400*50). Total withdrawal from people under ‘black

category’ thus would be INR387b (19m*INR20,000). Thus, gross deposits of

INR3,866b and total withdrawal of INR387b implies net deposit of INR3,479b under

‘black category’.

Thus, total withdrawal from all two categories of people would be INR12,281b

(INR11,894b + INR387b), as against gross deposit of INR11,597b. It implies that the

outstanding amount of banking deposit at the end of March 2017 would be lower

than pre-demonetization expectation by INR684b.

However, it does not mean that banks would not benefit from demonetization. The

gains could emerge from higher investment in G-secs, leading to trading gains.

In case, higher deposits are

outdone by withdrawals,

the rally in yields and

banking stocks could prove

to be short-lived.

Nevertheless, the net impact will be crucial in determining the sustainability of the

recent sharp fall in bond yields and the surge in banking stocks. In case, higher

deposits are outdone by withdrawals, the rally in yields and banking stocks could

prove to be short-lived.

21 November 2016

India Strategy

How could change in assumptions impact estimates of net accretion to

banking deposits?

Since there are five key assumptions, we look at how a change in each assumption

impacts the bottom line for the impact on banking deposits. Exhibit 7 below

summarizes the impact of a change in each of these five assumptions.

#1: The lower (higher) the share of white money, the more (less) favorable it is for

the banking system.

#2: A higher (lower) portion of declared black money (or lower (higher) unclaimed

portion) will be highly advantageous for the banking system.

#3: An assumption of higher (lower) deposit per person under ‘white category’ will

be beneficial (harmful) for the banking system.

#4: An assumption of higher (lower) deposit per person under ‘black category’ –

assuming the same portion is declared – will be beneficial (harmful) for the

banking system.

#5: A lower (higher) withdrawal per day will be highly positive (negative) for the

banking sector.

Exhibit 7: How change in assumptions change the impact of demonetization on banking deposits in FY17

Share of white money* (%)

#1: Net impact on banking deposits as the share of ‘white money’ changes

#2: Net impact on banking deposits assuming the entire (100%) black

money is declared

#3: Net impact on banking deposits assuming higher deposit of

INR15,000/person under ‘white category’ instead of INR13,000

#4: Net impact on banking deposits assuming higher deposit of

INR250,000/person under ‘black category’ instead of INR200,000

#5: Net impact on banking deposits assuming withdrawal of

INR300/day/person instead of INR400

* Assuming 50% of total black money is unclaimed

5,430

11,692

5,747

5,569

6,198

3,901

9,468

4,536

4,025

5,245

844

5,019

2,113

937

3,339

(684)

2,795

902

(607)

2,386

(2,212)

571

(309)

(2,150)

1,433

(5,269)

(3,878)

(2,732)

(5,238)

(473)

Source: MoSL

21 November 2016

India Strategy

Impact on money supply measures…

The more the new

deposits, the lower the

currency in circulation.

As far as the impact on high-powered money supply (M0) is concerned, it will fall by

the amount of the currency which does not return to the banking system. Further, a

change in banking deposits will also have an impact on outstanding currency in

circulation (CIC). The more the new deposits, the lower the currency in circulation.

Moreover, higher deposits will also lead to an increase in bankers’ deposit with the

RBI; however, we ignore this for simplicity purposes.

Taking forward our example with 50% of total CIC as ‘white money’ and 25%

remaining unclaimed, banking deposits will be lower by INR684b. Thus, CIC forecasts

will change by INR3,182b (INR3,866b -INR684b). The new amount of outstanding

currency in circulation at end-March 2017 would be INR15,595b, as against our pre-

demonetization forecast of INR18,776b. It implies that CIC will decline 6.3% YoY in

FY17.

As far as the impact on broad money supply (M3) is concerned, the impact would

always

be equal to the amount of undeclared/unclaimed portion of black money. It

means M3 would be lower by INR3,866b at INR125,223b, implying growth of 7.8%

YoY in FY17, as against our pre-demonetization expectation of +11.1% and market

consensus of +11.5%-12%. The impact is summarized in

Exhibit 8

below.

Higher money multiplier

implies that the RBI needs

to print lesser amount of

currency or boost M0 by a

lesser degree to achieve the

same growth in broad

money supply (or M3).

…and related money multiplier

Money multiplier, it implies, would move up from the current level of 5.54 to 6.02.

The exhibit below calculates the change in money multiplier under different

assumptions. Higher money multiplier implies that the RBI needs to print lesser

amount of currency or boost M0 by a lesser degree to achieve the same growth in

broad money supply (or M3).

Exhibit 8: Impact of money supply measures in FY17

Share of white money (%)*

High-powered money supply, M0 (INR b)

Broad money supply, M3 (INR b)

Change in M3 (% YoY)

Money multiplier (=M3/M0)

* Assuming 50% of total black money is unclaimed

11,583

122,130

5.1

10.54

13,884

122,903

5.8

8.85

13,293

124,449

7.1

6.73

15,595

125,223

7.8

6.02

17,896

125,996

8.5

5.46

22,499

127,542

9.8

4.61

FY17#

23,971

129,088

11.1

5.39

Source: MoSL

# Our pre-demonetization forecasts

21 November 2016

India Strategy

Estimating short-term impact on GDP

According to Late Milton Friedman, inflation is always and everywhere a monetary

phenomenon. However, “the velocity of money” plays a very important role, which

would change the link between money supply and total spending significantly. A

fast-growing economy with fast-growing money supply may not necessarily be

inflationary because of quickly rising velocity of money and vice-versa. Following the

quantity theory of money (QTM) in its simplest form, money supply is linked with

total spending (or GDP). The QTM says:

M*V=P*Y

Where, M = money supply (M3), V = velocity of money, P = price level, Y = real GDP

The equation says that the stock of money (M) multiplied by the velocity of its

circulation (V) is equivalent to real GDP (Y) multiplied by price level (P) or nominal

GDP (P*Y).

The equation, in its original form, linked money supply (M) with inflation (P) and real

GDP (Y), as velocity (V) was assumed to be constant over a longer period. However,

since this equation is an identity, it must hold every time. We believe that velocity of

money may remain broadly unchanged over the longer period; however, once in a

lifetime event such as ‘demonetization’ has the potential to affect velocity

significantly over the near term. Moreover, since prices could also be sticky in the

near term, QTM could reflect the change in nominal/real GDP due to an abrupt

change in money supply (M) and/or velocity (V).

Once in a lifetime event

such as ‘demonetization’

has the potential to affect

velocity significantly over

the near term. Moreover,

since prices could also be

sticky in the near term,

QTM could reflect the

change in nominal/real GDP

due to an abrupt change in

money supply (M) and/or

velocity (V).

Fall in real GDP growth could be more than 1pp in FY17…

If, as per our base case, M3 turns out to be INR125,223b at end-March 2017, the

impact on nominal GDP will be determined by the velocity of money. At end-FY16,

M3 was INR116,176b and nominal GDP was INR135,761b. It implies that the velocity

of money was 1.17x.

Assuming that the M3

velocity is unchanged from

our pre-demonetization

expectation of 1.17x at end-

March 2017,

Assuming that the M3 velocity is unchanged from our pre-demonetization

expectation of 1.17x at end-March 2017, outstanding M3 of INR125,223b implies

nominal GDP of INR146,890b in FY17, as against our pre-demonetization forecast of

INR151,424b. It implies nominal GDP growth would be 8.2% in FY17, as against our

pre-demonetization expectation of 11.5% (see

Exhibit 9

below).

The impact on real GDP growth would be determined by the (dis)inflationary

process. We believe that even if disinflation happens, it would materialize after a lag

of almost six months. FY17 inflation expectations, thus, are unlikely to witness any

major shift. We expect GDP deflator to grow 3.6% in FY17. A nominal GDP growth of

8.2% in FY17 implies a real GDP growth of 4.5% - down from pre-demonetization

expectation of 7.7%. An estimated real GDP growth of 7.4% YoY in 1HFY17 implies a

GDP growth of less than 2% in 2HFY17

(Exhibit 9).

FY18 onward, however, as money supply growth and the velocity remain normal,

real GDP growth would also move toward the normal level. In fact, if

demonetization triggers disinflationary forces, real GDP growth for FY18 could be

even better than the current forecasts.

A nominal GDP growth of

8.2% in FY17 implies a real

GDP growth of 4.5% - down

from pre-demonetization

expectation of 7.7%. An

estimated real GDP growth

of 7.4% YoY in 1HFY17

implies a GDP growth of

less than 2% in 2HFY17

21 November 2016

India Strategy

Exhibit 9: Impact of demonetization on GDP growth in FY17

Share of white money (%)

Velocity of money (Unit)

M3 at FY17-end (INR b)

122,130

Nominal GDP in FY17 (INR b)

143,262

Nominal GDP change in FY17 (% YoY)

5.5

Real GDP growth in FY17 (% YoY)

1.9

Nominal GDP growth in 2HFY17 (% YoY)

Real GDP growth in 2HFY17 (% YoY)

# Pre-demonetization forecasts

122,903

144,169

6.2

2.5

124,449

145,983

7.5

3.8

1.17

125,223

146,890

8.2

4.5

125,841

147,615

8.7

5.0

6.7

2.8

127,542

149,611

10.2

6.4

9.5

5.6

FY17#

129,088

151,424

11.5

7.7

12.0

7.9

Source: MoSL

0.6

1.9

4.4

5.7

(3.2)

(1.9)

0.6

1.8

Assuming 50% of total black money is unclaimed

…however, velocity of money holds the key

There will be at least two

factors pushing velocity

higher and one major

change leading to an

adverse impact on velocity.

Nevertheless, there will be two contrary forces at work most likely changing the

actual velocity of money by March 2017. There will be at least two factors pushing

velocity higher and one major change leading to an adverse impact on velocity. First,

a number of transactions would be advanced to get rid of INR500/1,000 notes and

get them converted into physical goods. Second, it is likely that a portion of

unclaimed currency in circulation already had zero velocity, as it was stashed under

the mattresses. Thus, lower currency to the extent that it already had no velocity

will not impact velocity. For instance, all other things constant, if 10% (INR1,660b) of

the total currency in circulation in FY16 was stashed under mattresses and thus had

zero velocity, the adjusted velocity in FY17 would be 1.19x (135,761/(116,176 –

1,663)). With higher velocity and unchanged M3, nominal GDP growth would be 9%

for FY17

(exhibit 10).

In contrast, the recent demonetization would also impact the velocity of money

adversely as the number of transactions could be much lower. Discretionary

spending is most likely to witness some pressure in the near term because of the

cash crunch.

Overall, it is highly difficult to estimate the adjusted velocity after taking these

factors into consideration. Thus, the adjusted (or new) velocity of money could be

higher or lower depending on which force is more aggressive.

Exhibit 10

below

shows the change in nominal GDP growth forecasts with changing velocity,

assuming new M3 of INR125,223b at end-March 2017. There is no doubt that the

velocity of money is the key to determine the change in FY17 GDP forecasts.

Overall, it is highly difficult

to estimate the adjusted

velocity after taking these

factors into consideration.

There is no doubt that the

velocity of money is the key

to determine the change in

FY17 GDP forecasts.

Exhibit 10: Impact of demonetization on GDP growth in FY17

Adjusted Velocity of money (Unit)

M3 at FY17-end (INR b)

Nominal GDP in FY17 (INR b)

Nominal GDP change in FY17 (% YoY)

Real GDP growth in FY17 (% YoY)

Nominal GDP growth in 2HFY17 (% YoY)

Real GDP growth in 2HFY17 (% YoY)

Assuming 50% of total black money is unclaimed

142,754

5.2

1.5

(0.1)

(3.9)

144,006

6.1

2.4

1.6

(2.1)

145,258

7.0

3.3

3.4

(0.4)

1.14

1.15

1.16

1.17

125,223

146,890

8.2

4.5

5.7

1.8

147,763

8.8

5.1

6.9

3.0

148,458

9.4

5.6

7.8

4.0

150,646

11.0

7.1

10.9

7.0

Source: MoSL

1.18

1.19

1.20

21 November 2016

India Strategy

FY17 GDP growth unaffected by net impact on banks

GDP growth in FY17 will not

be affected by the net

impact on banks.

Finally, it is also important to note that GDP growth in FY17 will not be affected by

the net impact on banks. This is because M3 and velocity will matter the most for

nominal GDP growth in the short run and both these variables are unlikely to be

affected by higher/lower bank deposits (since this will be at the cost of lower/higher

currency in circulation). Moreover, since prices remain sticky in the short term, real

GDP growth is also likely to be disconnected with the net impact on banks.

Over the medium to longer period, however, the change in bank deposits will play

an important role in determining the interest rate structure, which will affect other

macroeconomic variables.

The entire impact of demonetization on GDP will channel through M3, which will get

affected to the extent of money that does not come back into the banking system.

The higher the amount of currency in circulation that gets destroyed or

extinguished, the more detrimental it will for GDP growth given the velocity of

money.

Exhibit 11

below summarizes the impact of demonetization on nominal/real GDP

growth. Assuming 10% of the currency in circulation (INR1.8t) does not return to the

system, nominal GDP growth could be 10% YoY in FY17, as against our pre-

demonetization expectation (and market consensus) of 11.5% YoY. Since the impact

on inflation is likely to come with a lag – possibly in FY18 – real GDP growth could

fall by the same extent to 6.2% in FY17, as against our pre-demonetization

expectation of 7.7%. It implies that real GDP growth in 2HFY17 could be

only

5%, as

against 7.4% in 1HFY17. As far as the impact in FY18/FY19 is concerned, assuming

things turn to normality; real GDP growth could get some extra boost due to

disinflation.

Further, as we showed above

(Exhibit 10),

given M3, GDP growth is directly impact

by the velocity of money.

Exhibit 11: Impact of demonetization on GDP growth in FY17

Unit

FY17#

Ghost CIC

Nominal GDP growth

Real GDP growth

% of total CIC

INR b

% YoY

n/a

11.1

11.5

7.7

7.9

889

10.3

10.8

6.9

6.5

New FY17 estimates after demonetization

10%

1,777

9.6

10.0

6.2

5.0

15%

2,666

8.8

9.2

5.5

3.6

20%

3,555

8.1

8.5

4.7

2.2

25%

4,443

7.3

7.7

4.0

0.7

30%

5,332

6.5

6.9

3.2

(0.7)

Source: MoSL

Real GDP growth in 2HFY17

% YoY

# Our pre-demonetization expectation

Please see inside for details

21 November 2016

India Strategy

Conclusion: Will demonetization lead to creative destruction?

Demonetization has captured the entire nation’s attention since its announcement

on November 8, 2016. Ordinary citizens are assessing how (and if) the move will

affect their everyday life, and many analysts in the financial markets are busy

estimating its impact on various financial/macroeconomic parameters.

Although it is widely

believed that the banking

sector will emerge as the

key beneficiary of this

scheme over the near as

well as longer term, our

model makes it clear that

this may not be the case.

In this note, we have provided an easy-to-use model, using which our clients could,

with their own assumptions, get an estimate of the economic impact of

demonetization on various important financial/macroeconomic variables such as

banks, money supply and GDP. Although it is widely believed that the banking sector

will emerge as the key beneficiary of this scheme over the near as well as longer

term, our model makes it clear that this may not be the case. Since depositing

money is a one-time activity (precisely what is happening now), while withdrawal is

a recurring process, net accretion to banking deposits at end-March 2017 would be

different from the numbers witnessed in the first few days of the scheme.

The quantity theory of money (QTM) equation used in our note originally links the

change in money supply with nominal/real GDP, since velocity of money is

considered broadly constant over the longer period. However, once in a lifetime

event such as ‘demonetization’ has the potential to affect velocity significantly over

the near term. Moreover, since prices could also be sticky in the near term, QTM

could reflect the change in nominal/real GDP due to an abrupt change in money

supply (M) and/or velocity (V).

The higher the amount of

unclaimed currency in

circulation that does not

return to the banking

system, the more will be

the impact on M3, and thus,

for any given velocity of

money, lower will be the

nominal/real GDP growth.

Thus, the higher the amount of unclaimed currency in circulation that does not

return to the banking system, the more will be the impact on M3, and thus, for any

given velocity of money, lower will be the nominal/real GDP growth. Assuming 10%

of the currency in circulation (INR1.8t) does not return to the system, nominal GDP

growth could be 10% in FY17, as against our pre-demonetization expectation (and

market consensus) of 11.5%. Since the impact on inflation is likely to come with a lag

– possibly in FY18 – real GDP growth could fall by the same extent to 6.2% in FY17,

as against our pre-demonetization expectation of 7.7%. It implies that real GDP

growth in 2HFY17 could be

only

5%, as against 7.4% in 1HFY17. As far as the impact

in FY18/FY19 is concerned, assuming things turn to normality; real GDP growth

could get some extra boost due to disinflation.

Further, given an estimate of M3, GDP growth will be directly impacted by the

velocity of money. The lower the velocity, the lower the GDP growth and vice-versa.

‘Short-term pain but long-term gain’ is the broad consensus in the market.

Nevertheless, while short-term pain, in terms of GDP growth, is almost inevitable,

we don’t know how short this short-term will be. Further, the intent of the scheme

is to destroy a portion of black money stock lying with the people, hoping that this

destruction will be construction over the long-term. We hope this idea of creative

destruction actually turns out to be the case.

21 November 2016

India Strategy

Research Gallery

21 November 2016

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