Mumbai

India

+91 99678 36663

+91 90049 36663
SEBI registered investment adviser (INA000004401), Mumbai.
16th December 2017

Mumbai

India

+91 99678 36663

+91 90049 36663

Manek Insights

Economic implications of the demonetisation of bank notes

09 November 2016
Mumbai, India

By
Sonesh N. Dedhia
M.D., Manek Financial Advisors Pvt. Ltd.

From today existing currency notes of Rs.500 and Rs.1000 have been demonetised in an abrupt move with the objective of weeding out black money from the Indian economy. I am here to talk about what could be the possible implications for the Indian economy and personal finance in particular.

WHO LOSES PURCHASING POWER DUE TO DEMONETISATION

There are three types of people who will lose a lot of cash as they will not be able to convert them. That is good for the economy in the long run and bad for certain industries in the short term.

In the first group are those who are engaged in illegal businesses – illicit liquor, arms, counterfeit medicines and all other counterfeit products. They have their blood sucked out by this measure. That economy suffers badly in the short term. All employees of these trades will be hit badly as well. For example, if someone is an employee stitching fake branded leather bags, he probably does not even know that he is in an illegal business. There is a huge number of people earning their living from this, apparently legal but actually illegal, industry. Counterfeit products and the banned substances can only be sold in cash. Employers and employees of this industry will suffer badly in the short term. Afterwards, it will become normal as they will be guided by the need of the population. In six months time the counterfeit industry and banned substances trade will go back to normal.
In the second group we have people who have corruption money. Misusing their position in the government or private companies they acquire the wealth. They may have converted some of their ill gotten money into gold or real estate. But they must be having a lot of cash anyway, especially because of the recent Diwali thanksgiving. They have always been interested in converting the black money into white. However, in the recent past, extreme digitisation of all processes may have created a lot of barriers for such conversions. That is why, I think, they were sitting on a huge pile of cash which becomes trash.
The third and final group consists of people who simply did not pay tax on their income and created black money. There are three subgroups within them.
  • Those who must generate black money to pay for corruption, like logistics companies, manufacturers (for temporary workers and licenses), pharmaceutical companies (for gratifying doctors), finance companies (to pay for references), etc., etc.
  • Those who sell agricultural and farm products in the open market. Farmers are exempted from taxes, but not the traders. Since consumers pay in cash nobody declares his actual income. This is a huge source of black money in India. Their entire savings is in agricultural land, cash or gold.
  • The biggest subgroup are those people who are habitual offenders: In the past India used to have a very high level of tax. That was when the menace of black money started. People simply refused to declare their actual income and pay corrupt officials to find their way out of legal problems. That habit still continues. Though tax rates are much lower today than in the past, the lack of fear for the tax departments and extreme trust in corruption push businesses to hide income. That money is used to fund a lot of expenses, purchase of luxury products and jewellery, invest in stock market through shadowy routes, and buy real estate.

WHAT HAPPENS WHEN ALL THE AFORESAID PEOPLE LOSE SOME OF THEIR PURCHASING POWER

Black money increases demand of all products either directly or indirectly. All those industries where sales happens in cash, and there is no regulatory requirement to identify the buyer, black money is used. Restaurants, entertainment, travelling, clothes and apparels, grocery, medicines, and so many others do not require identification of the buyer. That is why whosoever has black money rarely pays for these with white. Books of accounts of a black money holder will invariably show some cash withdrawal, but not to the extent of the person’s actual expenses. By doing so stays clear in the eyes of the law but fuels a lot of demand into the economy. On the other hand his unspent white money gets invested in the stock market or his business and other activities. That is how black money indirectly influences the demand in the investment market. Real estate is a major sink of black money. Sellers as well as buyers do not declare actual sale price of a land, house or apartment, and thereby avoid stamp duties and utilise black money. When our black money hoarder suddenly loses his cash it will cause sudden decrease in demand for consumer goods, real estate and investment products. As a result of that all employees of those industries will suffer. That will further lower the demand in the economic system.

When demand comes down because of evaporation of black money, there will be a cooling effect on the prices across the board. It may be termed as deflation, but it is not. It is a reality check for the economy. The growth going forward will not be an inflationary one, but a real growth in the economy. Some industries, like real estate, will suffer more. Stock markets will drop substantially and valuations will become realistic.

WHICH INDUSTRIES WILL SUFFER IMMEDIATELY

The following industries will see a sudden drop in demand because of non-availability of cash.

  1. Real estate
  2. Speculative stock investment
  3. Clothes and apparels
  4. White goods
  5. Alcoholic drinks
  6. Gold and Jewellery
  7. Second hand cars
  8. Entertainment
  9. Travel

WHICH INDUSTRIES WILL SUFFER IN THE LONG RUN

The measure of demonetisation will bring in a high level of frugality in the market. Consumers, having seen such a turmoil, will be cautious about spending. That is the biggest worry for the economy going forward. Demand of all consumer goods will remain low for a very long time. I think, we are going to have a two year of frugality winter. I can clearly see a prolonged lull in the following industries due to frugality. Either consumers will not buy them or they will buy cheaper alternatives.

  1. Clothes and apparels
  2. White goods
  3. Alcoholic drinks
  4. Pharmaceutical products
  5. Entertainment
  6. Travel

WHICH INDUSTRIES WILL PICK UP AFTER SOME TIME

After the cash circulation normalises, some industries will pick up steadily. Frugality with living expenses will further fuel these industries.

  • Stock investments
  • Gold
  • Real estate

People will look at investments very seriously. Their approach towards investment will change from speculative to long term predictable growth. That is why investment in blue chips, mutual funds, debt funds, and gold will go up after the shock period is over. Real estate prices will normalise in the first phase. Thereafter the customer will come back to the market. That will fuel a long term growth of the real estate business. Many small time developers and builders may perish in this turmoil. Therefore, the new growth will be enjoyed primarily by corporatised big companies.

OTHER ARTICLES

Why do quarterly results attract so much attention?

Quarterly results are a major concern for investors and usually they are anxious to know what’s happening in the company they have invested. The results announcement is a window made available to investors to understand the company’s performance. Even it’s an opportunity for companies to publish its accomplishments during the quarter.

The financial performance shows how much the company earned as revenue, how much it spent under various heads to earn the same and how much it retained as profits for its investors. More specifically, investors care more about how earnings per share are improving because they ultimately drive stock prices.
Since the stock markets are usually driven by quarterly reporting of financial performance, everybody is infatuated with the quoted numbers in the financial statements, attracting the most attention and media coverage. Before the reports come out, stock analysts issue forecasts and by knowing the potential impact an earnings report can have on a stock beforehand, the investor tries to take advantage of the earnings season. If the results are better than expected, more people will want to own the stock and share prices will go up. But if the company results fail to match investor expectations, some people might want to exit from the company and, as a consequence, share prices will fall.

But is trading on quarterly results the right approach for investors?

A common saying says “Don’t judge a book by its cover”. Equally valid words of wisdom for investors could be “Don’t judge a stock by its price”. Investors often make the mistake of looking only at the stock prices because it is the most visible number. Strong earnings generally result in the stock price moving up (and vice versa). But, many a time the market does not immediately and accurately price a stock based on released earnings report. Stock prices adjust to the numbers and future expectations based on newly available information. The company can be doing very well and have excellent fundamentals. But its price may fluctuate due to industry performance, investor sentiments and other economic factors.

During the announcement of results the stocks are highly volatile and by engaging into speculative activity of trading the capital is at very high risk and often investors tend to lose money. However, staying invested over the long term has historically paid off well. So, let’s get on with getting long.

In India most investors go to any extent to save income tax and run around to make last minute investments. Last minute tax planning is an age old practice that forces tax payers to make hasty and often wrong decisions. Typically, some individuals invest more than the required amount to save taxes. They also end up parking money in wrong products in the process, which may have an adverse impact on their cash flows and return prospects.

It is not surprising that the insurance industry do most of its business during the tax- saving season between January and March every year. Often investors tend to buy products or make investments without doing the due diligence on their total tax structure. Investors happily write out cheques to buy low-yield traditional insurance policies or take additional medical cover as long as it saves their income tax. But this enthusiasm to avoid the taxman is missing when they invest in debt instruments.

Your tax-saving investments should depend on your financial needs and goals. These should be distributed among assets classes to reap the dual advantage of lowering tax burden as well as building your portfolio. Equities are known to offer high return over the long term. However, it does not mean you should ignore debt investments.

The safety factor of debt funds

Debt funds are a direct alternative and competitor for bank fixed deposits. The primary areas of difference are safety and taxation (and thus returns), with mutual funds holding the advantage in tax-adjusted returns and fixed deposits in safety.

In theory, banks are safer but, there is no practical difference between the safety level of banks and debt funds as far as defaults of underlying investments go. As with all mutual funds, there are no guarantees in debt funds. Returns in debt funds are market-linked and the investor is fully exposed to defaults or any other credit problems in the entities whose bonds are being invested in.

However, in practice, the fund industry is closely regulated and monitored by the regulator, Securities and Exchange Board of India (SEBI). Regulations put in place by SEBI keep tight reins on the risk profile of investments, on the concentration of risk that individual funds are facing, on how the investments are valued and on how closely the maturity profile hews to the fund’s declared goals.

In the past, these measures have proved to be highly effective and except for some small problems during the 2008 global financial crisis, debt fund investors have not had any nasty surprises. Practically speaking, you would be entirely justified in expecting not to face any defaults in your debt fund investments.

Fixed deposits, recurring deposits and small savings schemes get a big chunk of the household savings pie, while tax-efficient debt funds make do with small fragment. More than Rs 4,90,000 crore of household savings are in bank deposits, while debt fund investments by individuals add up to about Rs 18,300 crore. This minuscule allocation to debt funds is despite the huge tax advantage and other benefits that these schemes offer.

The effect of tax differential

Returns from bank fixed deposits are interest income and as such have to be added to your normal income. Since many investors are in the top (30 per cent) tax bracket, this effectively reduces return by an equal percentage.

With debt funds, the returns are classified as capital gains for investments of over 12-months for and are thus taxed at 10 per cent or 20 per cent with indexation which adjusts for inflation during the holding period. If you take into account indexation benefits, then the difference between FD returns and debt fund returns are quite large. And if you can time the investment to get double indexation benefits for say a 370 day deposit, then it’s quite a bonanza. Below is an illustration of effective returns from both the avenues;

Particulars

Income Funds

Bank Fixed Deposit

Investment Amount (Rs)

1,00,000

1,00,000

Rate of Return/Interest Rate (%) (p.a.)

10%

10%

Tenure (Days)

366

366

Gross Value after 1 year (Rs.)

1,10,000

1,10,000

Gain on Investments

10,000

10,000

Capital Gain Tax (@11.33%)

1,133

Tax on Interest Income (@30.9%)

3,090

Net Value after tax (Rs)

1,08,867

1,06,910

Effective Rate of Return (%)

8.87%

6.91%

Postponing the tax liability

The lower tax rate on capital gains, for instance, is just one of the benefits of these schemes. A major draw is that one can indefinitely postpone tax liability by investing in debt funds. The interest income is taxable on an annual basis, irrespective of the time that investor actually get it. Investor need to pay tax on the interest accruing on a cumulative fixed deposit or a recurring deposit even though the instrument has to mature in 5-10 years.

On the other hand, investments in debt funds will not have a tax implication till it is withdrawn. This also makes these funds the best way to invest.

Taking Advantage of Clubbing of Income

When the money is invested in minor child’s name, the income from the investment is treated as that of the parent who earns more. This clubbing of income is meant to prevent tax leakage, but investments in mutual funds can circumvent this provision. If the funds are redeemed after the child turns 18, the capital gains will be treated as the child’s income, and not parents.

Setting off Losses

There are other ways to earn tax-free income from debt funds. You can set off losses from other assets against the gains from these schemes. Tax rules allow carrying forward of capital losses for up to eight financial years. For instance, if you had booked short-term losses on stocks and equity funds when the markets slumped in December 2008, you can adjust them against the gains from your debt fund investments till 2015-16.

What if you need the money before one year? Any short-term capital gain is taxed as income, but you can get past this with the dividend advantage. Though they are tax-free, dividends of debt schemes reach the investor after the deduction of dividend distribution tax. This is 28.325% for debt funds and liquid funds. Even so, this is lower than the 30% tax an investor in the highest income bracket will pay on withdrawals before one year of investment.

Liquidity Advantage

Apart from these tax advantages, debt funds also offer a higher liquidity and more flexibility than a bank deposit. When you invest in a fixed deposit, you lock up money for a certain period. Sure, the deposit can be broken any time, but you end up sacrificing returns. There is usually a small penalty to be paid when you withdraw prematurely.

Debt funds also levy an exit load, but the quantum of load as well as the minimum period of investment varies across funds and categories. Most liquid funds and ultra short‐term funds, for instance, do not have exit loads, but medium‐term income funds may charge 0.25‐0.5% if you leave within six months or a year of investment. In some cases, this may even be as high as 1‐2%. So it pays to check the exit load and minimum investment period before you buy a fund.

Flexibility

The other advantage is the flexibility and ease of investment. The Public Provident Fund has annual limits—the minimum investment is Rs.500 and the maximum Rs 1 lakh. The tenure is fixed at 15 years but can be extended in tranches of five years. The Senior Citizens Savings Scheme has a maximum limit of Rs 15 lakh per individual and is for five years. No such limits apply to mutual funds. You can invest as much as your pocket allows. “Unlike small savings schemes, there is no limit to how much an individual can invest in debt funds,”

Besides the convenience of SIP investing, facilities such as systematic transfer plans (STPs) and systematic withdrawal plans (SWPs) make things easier for the debt fund investor.

Unaware of debt funds as a fixed income product, many investors opt for Banks fixed deposits or small savings schemes. But, Debt funds if used properly and selected wisely can be a good alternative to other fixed income investments.