"Brace For Economic Disruption" SocGen Sees "Sharp Rise In Gold" As India Plans Cap On Cash Holdings

India's 'de-monetization' scheme has caused chaos across the nation, and while SocGen says the government's plan may have some short-term success in curbing so-called 'black-money', investors should "brace for economic disruption" as Bloomberg reports the Indian government is considering a cap on cash holdings for individuals. As SocGen concludes, "people will now be more inclined to park their black income in gold rather than in currency."

The daily images of utter chaos in India that has brought the conutry's economy to a standstill since they unleashed their war on cash...

Are perhaps about to get worse, as Bloomberg reports, India is set to consider a cap on cash holdings for individuals...

Measure planned to prevent people from hoarding cash and generating income that could evade taxes, according to government officials with direct knowledge of the matter.


Planned measures include limit on large cash withdrawals from bank, the officials said, asking not to be identified citing rules on speaking to media.


Budget, due in February, may have steps to encourage use of checks, credit and debit cards.


Purchase of gold jewelry said to be made more stringent to prevent switching of asset from cash.


Finance Ministry spokesman D. S. Malik couldn’t be reached for comment.

But, as SocGen's Kunal Kumar Kundu writes, the demonetisation scheme (banning the use of old high-denomination banknotes – INR500 and INR1000) announced by India’s PM Modi on 8 November is likely to have only a short-term impact on corruption and black money, unless it is followed by multiple other moves aimed at curbing these issues.

However, we do expect short-term disruption to the economy, especially in rural areas, due to a sharp drop in consumption as the cash crunch hits. The extent of the disruption will depend on how soon new banknotes come into the system. If this takes place over the next three to four weeks (as promised by the government) the damage should be limited. Otherwise, the disruption could be prolonged. At the same time, there is also a possibility of a short-term increase in tax revenue collection which could enable the government to keep its deficit within target and continue with all its desired expenditure (including capex) which we earlier feared may have to be curtailed as deficit challenges manifested. In the interim, sectors that are heavily dependent on cash transactions (essentially because these are gateways to parking black income), i.e. construction, real estate and gems & jewellery, are likely to be adversely affected over the short term.

On the macro front, weaker consumption could mean lower inflation, thereby opening up the possibility of an earlier rate cut by RBI. Additionally, with people being forced to deposit large quantities of high-value notes, banks are seeing a surge in low-cost deposits which should lower cost of funds and result in faster transmission of monetary policy action through the interest rate channel. However, given the current weak credit environment, we see a spike in credit growth as unlikely. The only potential long-term effect of this move could be deterioration in India’s current account deficit (CAD), as people will now be more inclined to park their black income in gold rather than in currency, thereby leading to sharp rise in gold imports.

India’s fight against black money – the end has corrupted the means

At around 8pm on 8 November, India’s PM Modi announced, in a broadcast to the nation, that India’s INR500 and INR1000 banknotes would no longer be recognised as legal tender from midnight and that citizens would be able to exchange their existing notes of these denominations for other available (and legal) tender until 31 December 2016. The aim of the action was to counter tax evasion, counterfeiting and corruption. The idea of eliminating large denominations is that it makes it harder to hide large amounts of cash.

The problem with the move is that, in one fell swoop, just over 86% of all banknotes in circulation became just paper. Fact is, high percentage of transactions take place in cash in India, especially in the rural areas. The potential fallout from such a nationwide measure could have been averted if the government had been better prepared to handle the contingencies. However, the need for the government to keep the move a secret — so that tax evaders wouldn’t be alerted before the demonetisation took place — affected preparedness. Even Finance Minister Jaitley admitted that it would take two to three weeks to reconfigure the ATMs to handle the newer and larger notes. Given that India currently has about 202,801 ATMs all over the country, it could potentially take longer.

Existing loopholes have provided an escape hatch

Before discussing the economic impact of the move, it is important to understand the potential impact it could have on the existing block of black money in the economy and its ability to stop generation of further black money in the economy in the future. We think that while the existing stock of black money will be negatively impacted, only part of it will actually come to the fore. There are still many loopholes in the system through which a large portion of black money is able to enter the formal banking channel without the government’s knowledge. While the country is receiving virtually one notification per day from the RBI to plug loopholes that are coming to light (another indication of lack of preparedness), this process looks set to continue. Thus, only part of the black money will actually be reported and experts think that some of it will never come back.

Black money represents only a small fraction of black wealth

The problem is that black money forms only a small portion of the black wealth held in the economy. In the past five years, income tax raids have found that only 5-6% of black money is kept in hard cash. Moreover, those who have amassed a sizable amount of black money are equipped at finding ways around demonetisation by converting their existing cash into bullion, gold jewellery, real estate and foreign currencies through middle men. To that extent the demonetisation scheme will only impact part of the overall stock of black wealth in the economy.

The important thing is, however, to remember that black income is a flow concept and not a stock concept. Hence, the impact will only be temporary, and black money will eventually begin to be generated again as the move will have no impact on the generation of black income itself. This is because there are a large number of mechanisms by which such incomes are generated, and these may or may not depend on cash circulation. Normally, black income is generated by manipulating the books of accounts of businesses — revenues are understated while costs are overstated. Black income becomes a stock when it is parked – be it through property, gold, currency, etc. This scheme will only impact the black income that is parked in the form of currency. Given that only around 6% of black wealth is parked in currency form and only a part of that will be impacted, the overall impact of the measure is likely to be limited and of short duration.

Demonetisation is not enough to fight the black money menace

For a sustained crackdown on black money, multiple other attendant measures need to be taken to rein in black wealth generation. These include:

  • Direct tax reforms – While much discussion has taken place over the last decade, no action has been taken so far. There are indications that the government may want to implement reform in this area – widening the tax base, lowering tax rates and removing exemptions. If an announcement in this regard is indeed made during the forthcoming budget could be positive for the economy in the long term.
  • Transparency in political funding – In India, the process of political funding remains very opaque and has evolved into a major end-use for black money. Unfortunately, we are yet to see any concrete action to tackle this menace.
  • Agriculture income tax – Agricultural income is not taxed at all in India. For a country with such a poor direct-tax to GDP ratio, it is incomprehensible how virtually 15% of the economy remains untaxed. In fact, this has emerged as a significant conduit for tax evasion as a large chunk of income is shown as agricultural income and hence there is no incidence of tax.
  • Investment through the Participatory Notes route – Participatory Notes (commonly known as P-Notes or PNs) are instruments issued by registered foreign institutional investors (FII) to overseas investors who wish to invest in the Indian stock markets without registering themselves with the market regulator, the Securities and Exchange Board of India - SEBI. This anonymity allows many individuals with illbegotten wealth to invest in the Indian stock markets. Stricter measures need to be imposed to control the flow of such funds into the market.

Like the expected impact on black money, we believe the impact on counterfeit currency will also be temporary. For sure, the existing stock of such banknotes will be extinguished, but it will only be a matter of time before the counterfeiters get back into action.

Economic impact

In the short term, the effect is likely to be negative on balance. However, we do not expect any long-term impact from this policy alone.


We feel this move could be negative for consumption in the short term. In India, especially in the rural areas, cash transactions account for the largest share of overall transactions in the economy. In urban areas, it is less. However, the challenges are multiple. According to data from the finance ministry, only about 32% of India’s population has access to financial institutions like banks and post offices. Moreover, the distribution of banks is highly skewed, with around a third of all bank branches being concentrated in only 60 Tier 1 and Tier 2 cities/towns. More importantly, close to 60% of workers earn their wages in cash, of which more than half are daily wage earners. The majority of small mom-and-pop shops deal only in cash, especially in rural areas. With 86% of banknotes moving out of circulation at just a few hours’ notice and with a limited amount of cash being made available in lieu, the effect has so far has been quite disruptive. This is no surprise given that as per an estimate by the Fletcher School at the Tufts University, in India 86.6% of transactions by value were carried out in cash in 2012. While this figure would have come down since then, it will still be very high. The fact is that India remains largely a cash economy. According to the same Fletcher School study, the ratio of currency to GDP in India (12.2%) is higher than for countries like Russia (11.9%), Brazil (4.1%) and Mexico (5.7%). Changing age-old habits is a long-term process and the demonetisation will have caught a lot of people on the wrong foot. Also, as mentioned earlier, in an effort to keep the decision secret, the actual implementation fell short of expectations. Even the banks, which were responsible for implementing this enormous project, were kept in the dark, thereby affecting their preparedness. Whether normalcy will return in another month’s time, will depend on the government’s ability to make new cash available based on its stated timeline. Having said that we think that the stress in rural areas will persist for some time.

Overall, we expect consumption in urban areas to be lower, at least until December, while the impact on rural areas could continue for longer. Nevertheless, we will keep tracking the situation and by mid-January we should have a better sense of the level of demand


As some black wealth gets tracked, we expect a short-term spike in tax (and penal) revenue collection. This should allow the government to plug the gaping hole in the overall revenue collection budgeted for the year. Hence it should be able to maintain its fiscal deficit target for the year and continue with its overall expenditure plan (including capex), which we felt would be compromised by a build-up of revenue pressures. This benefit, however, will be a transitory in nature unless the move is followed by the tax reforms mentioned above. In the event that reforms do take place simultaneously, we would likely see a long-term structural improvement in the economy as government capex would continue unhindered resulting in more job creation.

Overall macro impact

GDP growth: The short-term demand destruction could be partly offset by continued government capex, which we previously expected to peter out. At this point we have limited visibility on the extent of the demand destruction that is likely to take place. On balance though, we see potential downside risks to our existing growth forecast. And the longer the disruption lasts, the greater the impact it will have.

Inflation: In the short term, we see potential downside risks to our inflation forecast given the demand destruction.

Monetary policy: With inflation likely to ease more than expected, there is a possibility of RBI opting for a rate cut at its December 2016 meeting as compared to our expectation of a rate cut at the April 2017 meeting. Also, with the vast amount of low-cost deposits flowing into the banking system, the banks are able to pass on the benefits of lower costs to lending rates, thereby improving the pace monetary policy transmission. However, we do not expect this to translate into higher credit growth. With credit growth currently at its weakest level, credit remains a demand issue and not a supply issue. Fiscal deficit: We believe the government will be able to meet its fiscal deficit target for the year (@ 3.5% of GDP) without having to compromise on its expenditure including capex. We had feared earlier that expenditure would be curtailed given that India’ fiscal deficit was already at 84% of the budget in the first half of FY17.

Current account deficit: The monetisation scheme could potentially lead to a higher deficit in the longer term as many of the people who generate black income could seek to park their income in gold rather than cash in anticipation of periodic repeats of the demonetisation scheme.

For now, the Rupee is in freefall...