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The government’s decision to withdraw currency notes with the denomination of 500 and 1,000 will lead to a short-term cash crunch and impact economic activity in sectors where cash transactions are high. For the banking sector, though, the decision could end up being positive in a number of ways.
From increased deposits to lower bond yields, banks may be among the short-term beneficiaries from the government’s decision. The move also opens up room for the Reserve Bank of India (RBI) to cut rates further, said some economists.
The first and immediate positive for the banking sector is a likely bump in their deposit base. Since a key reason behind this move is to nudge the parallel economy towards the formal sector, at least some part of the black money will be deposited into banks. This will mean increased liquidity for the banking sector.
Banks have been hamstrung, have weak deposit growth which has remained close to 10 percent and well below historical levels. As currency flows in, bank deposit growth will pick up.
One problem that has been baffling economists has been the increase in currency in circulation in the economy over the past year. While currency in circulation typically increases around festivals and elections, India has seen a consistent increase in this indicator, which has gone unexplained.
Increase in currency in circulation hits banking system liquidity and forces the RBI to infuse more funds into the system through purchase of government bonds (known as open market operations).
Demonetisation of 500 and 1,000 rupee notes will bring down currency in circulation and improve liquidity.
This morning, the benchmark 10-year bond yield has fallen by more than 10 basis points to below 6.70 percent. There are a number of dynamics at play in the bond markets.
The first of these, as detailed above, is improved liquidity in the banking sector which could impact demand for government notes. But there could be other dynamics at play. As the government moves to clamp down on black money and citizens deposit more funds in banks, the government may see an improvement in tax collections. This, in turn, would help the fiscal position of the government.
Another reason being cited for the fall in bond yields this morning is the possible decline in inflation as a consequence of this decision. As economic activity takes a temporary hit, inflation could come down, allowing the RBI to cut rates further.
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