Withdrawal Of Currency Notes: Three Ways Banks Will Benefit

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.

Increased Cash Flow to Banks

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.

We see tremendous long term benefits for banks as cash/parallel economy as a proportion to total economy declines. Interest rates will come-off (more deposits in the system) and credit off-take will improve (companies which are impacted due to parallel economy e.g building materials will benefit). Proportion of cash less transactions will go up benefiting banks in general.

Parag Jariwala, Vice President, Institutional Research, Religare Capital Markets 

Drop In Currency In Circulation

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.

There could be an immediate increase in bank deposits if some of the holders of these old notes decide to deposit them rather than exchanging them for new notes. Currency in circulation might decline substantially if heightened scrutiny forces people with unaccounted for cash to not exchange/deposit. The base money goes down in that case but the increase in money multiplier (because of a higher deposit to currency ratio) might mitigate the impact on overall money supply.

Samiran Chakraborty, Chief Economist, Citi India

Drop In Bond Yields

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.

We estimate that this could see disclosure of 1-2 percent of GDP. We see a 3-pronged impact. First, this should lead to lower yields as well as lower rates. After all, Rs 100 of cash that will be disclosed will result, in the first instance, of Rs 55 of bank deposit mobilisation and Rs 45 of taxation (assuming IDS 2016 tax rates) and by extension, lower fiscal deficit. As a result, we grow more confident of our call of a 75 basis point cut in bank lending rates by September 2017.

BofA Merrill Lynch Global Research