“The announcement to curb informal circulation of money is likely to be positive for banking system liquidity as well as medium-term fiscal resources and financialization, but negative for near-term economic activity,” Goldman Sachs said in a report released today.
The report said from an economic standpoint, this reform is likely to have material implications across money supply, consumption spending, fiscal policy and eventually inflation.
The pace of increase in currency in circulation had risen significantly over the past year to 17.3 per cent year on year in October 2016, contributing to nearly 20 per cent of the overall increase in money supply over the same time period.
“With individuals depositing their cash at bank accounts, we think M3 growth is likely to switch away from currency into bank deposits over the next month,” it said.
Nearly 10 per cent of total household financial assets are held in currency, higher than those held in equities and debentures.
It said the reform is a positive step over the medium-term as it increases transparency, accountability and shifts more transactions through electronic mediums and the banking system.
The undeclared cash when exchanged at banks over the next few months with an associated identity card, may be tracked by tax authorities and help increase the tax base of the economy, which is currently running below the regional average.
“This could help the government bring the fiscal deficit down to 3 per cent in the financial year 2017-18 from the budgeted 3.5 per cent in in the financial year 2016-17.”
The report said over the medium term, as more transactions take place via the banking system, the RBI should be able to bring the banking system liquidity to net neutrality more smoothly and consequently improve the effectiveness of monetary transmission.
From the growth perspective, the reduction in currency in circulation is likely to be negative for short-term consumer discretionary spending.
In particular, cash-heavy sectors such as jewellery, restaurants, food and beverages, transport, among others are likely to witness a drop in sales.
These sectors account for nearly 50 per cent of overall household spending. This places some downside risks to near-term growth, in our view.
Gold import demand is also likely to be impacted as a result of reduced end-consumer jewellery demand.
It said from the markets perspective, these measures should be positive for the rupee bond market.