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Nov 14, 2016 Economy & Strategy 1 Nov 14, 2016 Economy & Strategy Economy & Strategy Demonetization Impact Report India Research - Stock Broking Small Short Term Pain for Large Long Term Gain While everyone was bracing for the US presidential elections on Nov 08, 2016 evening, major news broke out in the form of the Indian Prime Minister’s sensational decision of nullifying Rs. 500 and Rs. 1000 notes, to take the black money problem head on. In independent India’s history, this is probably one of the most powerful economic decisions. It takes enormous guts to execute it, and Prime Minister Narendra Modi has displayed that. While the decision is excellent, the real success of this monumental decision lies in maintaining secrecy about it till the last moment. This move is clearly part of a broader well-calibrated agenda of the battle against black money, and is a clear follow-up to voluntary IDS (Income Disclosure Scheme) launched by the government. This move of nullifying Rs. 500 and Rs. 1000 notes makes it forceful income disclosure. The old Rs. 500 and Rs. 1000 notes will have to be deposited / exchanged with banks, which naturally brings even unaccounted Rs. 500 and Rs. 1000 notes into the regulator’s radar. The Prime Minister clearly mentioned during his speech that there may be some inconvenience for about 15 days in the execution of such a monumental decision. However, the long-term benefits of this move will far exceed a little discomfort for 15 days. The global investors will surely upgrade their Indian investment outlook, as this move will elevate perceptions regarding the transparency standards of the Indian economy. We have seen truly game changing move from government regarding demonetization of Rs. 500 and Rs. 1000 notes. The move has surely taken everyone by surprise, in terms of its sheer impact. Undoubtedly, this has become hot topic of discussion for people across the economic spectra ranging from Cab Drivers to Corporate Directors. While everyone is sensing the monumental nature of this decision, no one is in a position to make accurate quantitative assessment of this move considering the fact there are only conjectures regarding size of black market in India. However, sectors where there is higher component of Cash dealings such as Real Estate and Gold may have larger impact. One unintended victim of this measure is unorganized players, who deal in cash (not necessarily unaccounted; but the regular course of their client base). These unorganized players may also go through period of slowdown demanding the forceful alignment of their business models accommodating online transactions and non-cash dealings. Investment cycle is also expected to experience slow phase, as the re-adjustment process has to be completed adjusting to this new reality. Macros and Taxes By different studies, it is expected that the black money represents about one quarter of Indian GDP. The abrupt retraction of such large size of the market overnight expects to trigger slowdown of GDP growth for coming two quarters, backed by slow consumption and investment. However, this lost momentum in GDP growth can be expected to be recuperated post that two quarter period, with renewed clarity on the new currency re-set. Further, banks are expected to collect enormous amounts of CASA (Current Accounts, Savings Accounts) deposits during this currency deposit / exchange program that should elevate liquidity levels in the system enormously. Since this program launched, it is expected that Indian banking system has received deposits of about Rs.3 Lac Crores (~US$50 Bn). This can temper down the bond yields substantially, and can trigger fresh interest rate cut by RBI in the upcoming monetary policy meeting. With reduced interest rates, and with restoration of clarity, the investment cycle and GDP growth can come back strongly starting the calendar year 2017, as some people symbolically refer to in “Hockey Stick” format. As of FY15, the number of income tax assesses in India is about 52 Mn. With the current measures, there is an expectation that the number of people expected to come in tax net to move up substantially. Further, the Tax-to-GDP ratio which is currently at 5.5% is also expected to improve. Analyst Contacts For private circulation only. For important information about Karvy’s rating system and other disclosures refer to the end of this material. Karvy Stock Broking Research is also available on Bloomberg, KRVY<GO>, Thomson Publishers & Reuters Jagannadham Thunuguntla 040 - 3321 6296 [email protected] 2 Nov 14, 2016 Economy & Strategy Unaccounted Money Those having unaccounted money will have to choose one of the following: A. Do nothing with the unaccounted money To put in simple words, let the old Rs. 500 and Rs.1000 notes destroy / expire. In this case, the ramifications are: the economy will shrink to the extent money set to expire. However, the liability of the government / RBI to that extent will get reduced, giving additional leg room for government / RBI for infrastructure spending without stoking inflation. B. Deposit / Declare the unaccounted money Those who declare the unaccounted money may attract taxes and penalties tantamount to 60-100% of the money, which can result into huge wind-fall gain to Government in the form of one-time tax collection. By some studies, the amount of money government expected to attract in the form of taxes and penalties may equal one full year’s fiscal deficit. C. Adopt unofficial routes to launder money Those who adopt unofficial routes to launder money may risk attracting huge penalties and prosecution. However, the laundered money will come into official bank deposit routes, which may be long term positive for the size of the economy. Exhibit 1: Demonetization impact Variable Immediate Impact Medium-Long term Impact Liquidity Improve Balanced Leads to increase in liquidity with banks, due to increase in deposits. Tax collection Improve Excess liquidity in the market to be normalized by the government / RBI. Neutral/ Improve In the form of Taxes and Penalties, Government As income declarations increase, tax inflow is likely to go up due to Fiscal Deficit GDP may receive windfall one-time tax collection. increased base of tax net; and hence eventual increase in Tax-to-GDP ratio Reduce Neutral/Reduce from current levels of 5.5%. Increase in direct tax payments windfall to help As unaccounted funds enter the banking system, increase in tax inflow to government to handle fiscal deficit effectively. Reduce be compensated through increased government spending. Improve Reduction in most cash based transactions is yyCash influx in the banking system is expected to boost the economy likely to lead to slow-down in consumption and investment trends. through lending which in-turn is likely to improve consumer spending and investment by businesses. yySimultaneously, direct taxes are expected to increase immediately as the government is accepting tax in the form of old notes. This may narrow the fiscal deficit and improve government spending. yyExport and imports could be neutral to this effect. yyTherefore, total GDP is likely to improve. 10 year Govt Neutral / Reduce bond yields Depends on RBI/Government actions There may not be any effect immediately. yyIf interest rate is decreased by RBI, then bond prices will increase However, with the increased liquidity conditions in the system, 10-year bond yields leading to decline in bond yields. set to come down. Source: Company, Karvy Research 3 Nov 14, 2016 Economy & Strategy Exhibit 2: Impact of Demonetization on Sectors Sector Impact of Demonetization Auto & Ancillaries yyConsumer sentiment severely impacted across the country due to demonetization and near term liquidity issue impacting the demand for all the consumption items like Passenger Vehicles (PVs), Two wheelers and Commercial Vehicles (CVs) to some extent. We expect it would take at least 3-4 months for automobile industry to come back to normal. This would have a chain reaction to auto ancillary companies over next 2 quarters, particularly companies who have high dependence on domestic demand. yyWe expect two wheeler industry would be worst impacted, as 50% of the consumption of two wheelers is in rural India, which has higher proportion of cash transactions compared to banking linked transactions. We also expect sizable impact on Passenger Vehicles due to this issue, as ~35% of PV demand is through rural India. yyWe estimate short term impact on CVs, while with recovery in normal transaction, it would see early improvement, as this category is purely need based sales and has lower sensitivity to consumer sentiments. yyWe expect limited impact on tractor sales due to healthy cropping this time, favourable monsoon and good support financing support from banking institutions. yyWe see 1-2 quarters’ impact on majority of the automobile and auto ancillary companies, except few ancillary companies which have a global presence and higher revenue contribution from global clientele base. yyHowever, in the long term, once the currency re-set is completed, the auto and auto ancillary industry is BFSI expected to be improved. yyBank deposits are likely to increase significantly on account of surge in deposits from people which would widen the capital base of banks, primarily CASA (Current Account and Savings Account). This will reduce cost of borrowing for banks and simultaneously reduces the cost of lending. However, there would be some short to medium term headwinds on asset liability mix. yyNow people with an outstanding liability in both parallel & unparallel form may face short to mid-term pressures in terms of meeting the liabilities on time, which may further worsen NPA situation in the Indian banking system. yyA closer look at the housing finance sector and loan against property, which are completely linked to the real estate business, are likely to face significant headwinds. Housing finance companies are likely to witness considerable stress on loans given to real estate developers who may face liquidity crunch in short to medium term. In the case of falling property prices, the existing Loan to value (LTV) ratio of banks/finance companies would increase which may further increase the risk. yyDemonetization move to propel cashless transactions, during FY15 paperless transactions (credit/debit/prepaid cards, Electronic Fund Transfer, online mobile wallets) were Rs. 92 Lakh Crore. E-commerce (portals in India registered retail sales worth of $5.30 billion in 2014) has helped rising paperless transactions. National Optical Fibre Network (NOFN) project, that will connect 2.5 Lakh village panchayats with the internet, is expected to further boost paperless transactions. Visas, MasterCard are expected to be the biggest beneficiaries followed by banks and online payment websites such as Paytm, Freecharge, MobiKwik etc. yyMicrofinance segment may be impacted negatively in the short term as most of the transactions in the segment Building Materials are carried out in cash. However, things will return to normalcy once the re-set process is over. yyNow, the demonetization of the Rs.500 and Rs.1000 notes, expected to drastically impact the real estate sector, which in turn would surely slow down the basic building materials business in the near to short term. yyBuilding materials industry such as tiles, sanitary-ware, paints is completely dependent on real estate sector. The cash crunch may make tough for them to deal with the working capital requirements in the near term. yyThe market share of the organized sector is about 60%, when the unaccounted money is curbed from the society then the opportunities would improve for the organized players with narrowing of the price differences. yyFor the medium term, where the realtors have huge unsold inventory have to sell their spaces, would surely bring down the prices affordable for the buyers which in turn expected to help to pick up the building materials sector in the long run. 4 Nov 14, 2016 Economy & Strategy Sector Impact of Demonetization Cement yyThis will directly impact the cement off-take from both rural & urban housing markets as the considerable part of transaction happens through cash during construction. yyAs the agricultural land prices are likely to correct, it will lead to slowdown in monetization of land. Thus, it is expected to impact the construction activities like housing, irrigation (due to delay in accumulation of cash). yyCement dispatches are also expected to get impacted from logistics (as the transporters are raising issues Consumer Durables related to work stoppage by truck drivers due to non-payment). yyThe cash sales in the consumer durables are expected to witness an impact for the near term till the new currency comes into circulation. However, it is expected that the use of cards and cheques would compensate for some purchases, but overall the move to replace the existing high-denomination notes is expected to hurt sales in this segment in near term. yyThe demand for large consumer durables items such as apparels, white goods, apparel and the likes could also witness near term impact. yyHowever, this demonetization move may be long term positive for consumer durables with GDP set to improve and eventually consumers will get consumer financing at lower finance cost on the back of higher liquidity in Infrastructure the system. yyOverall pace of construction activities is likely to get impacted due to impending cash crunch with vendors and raw material suppliers. yyContractors/developers are expected to see some delay in receivables. Logistics yyDue to transportation hurdle, delay in construction activities is expected due to raw material availability issues. yyLogistics industry is expected to see an adverse impact on short term, with the prices are likely to correct in the short term with the reduced industry demand for movement of goods and also due to the cash component in transactions would come down. yyFrom clientele perspective, most of e-commerce clients of logistic companies deal in “Cash on Delivery”. By various measures, the Cash of Delivery transactions can be expected to reduce by 25% due to this demonetization move; and with their business getting hit of these developments, logistic companies performance is expected to adversely impacted in short term. Real Estate yyHowever, once the things stabilize, logistics sector can be expect to improve. yyProperty market is expected to see a big negative impact with the prices are likely to correct (as the cash component in transactions would come down). yyAgricultural land prices are also likely to get impacted as these also account for large amount of unaccounted cash. Conclusion We firmly believe that this episode may have small short term pain which can constructively build large long term gain. We believe: yyThe global investors will surely upgrade their Indian investment outlook from the medium to long term, as this move will elevate perceptions regarding the transparency standards of the Indian economy. yyGDP should revive back post two quarters of slowdown; and may knock on the door of double-digits due to enormous accretion to the size of official economy. yyCASA deposits and bank liquidity expected to substantially move up; which can offer enough leg room for RBI to reduce interest rates. yyBond yields are expected to move lower; which can offer additional funds to corporate at lower interest rates. yyOnline and Digital economies are expected to grow substantially, as more people are expected to use these digital routes for transactions. yyTax compliance perception is expected to improve, with increased number of tax assesses and improved level of Tax-to-GDP ratio. yyThe government is expected to gain firm control over fiscal deficit with higher tax collections. yyDigital and e-wallet companies will be the biggest beneficiaries, as cash-less may become norm going forward. 5 Nov 14, 2016 Economy & Strategy Connect & Discuss More at 1800 419 8283 (Toll Free) [email protected] Live Chat f in You Tube Disclaimer yy Analyst certification: The following analyst(s), Jagannadham Thunuguntla, who is (are) primarily responsible for this report and whose name(s) is/are mentioned therein, certify (ies) that the views expressed herein accurately reflect his (their) personal view(s) about the subject security (ies) and issuer(s) and that no part of his (their) compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report. yy Disclaimer: Karvy Stock Broking Limited [KSBL] is registered as a research analyst with SEBI (Registration No INH200003265). 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