Demonetisation and Economic Activity: Understanding the Reaction of India's Stock Markets

The worst hit sectors by demonetisation are the automobile, consumer and the realty sector. The banking sector, on the other hand, has had a differential impact.

A broker reacts while trading at his computer terminal at a stock brokerage firm in Mumbai, India. Credit: Reuters/Shailesh Andrade/Files

A broker reacts while trading at his computer terminal at a stock brokerage firm in Mumbai, India. Credit: Reuters/Shailesh Andrade/Files

The short-term pain of demonetisation is now evident. Long queues in front of banks, cashless ATMs and reduced small trade market activities bear testimony to it. A reliable criterion to gauge the immediate economic impact of a sudden policy shock is to observe stock market trends. Traditionally viewed as a predictor of the economy, sharp and persistent plunges in stock market indices could indicate deterioration in economic activity. On November 16, after a week into demonetisation, the daily closing price of NSE S&P CNX Nifty 50 index dropped by 5.1% as compared to November 8. This plunge made it the worst weekly close value since February. The Nifty 50 index is composed of firms from a varied set of industries. Does this reflect negative investor sentiment across all sectors?

An analysis of NSE data indeed indicates so. We study the price movements of major sectoral indices at NSE. These include: automobile, consumption, realty and banking sectors. The means of the closing value of the indices is compared for a period of 25 trading days before the event (October 3-November 8) with a period of 11 trading days after the event (November 9-November 24). The table below shows the impact.

Sectors Pre-Demonetisation returns (%) Post-Demonetisation returns (%) Difference (%)
Nifty Auto -0.08 -1.2 -1.12** 
Nifty FMCG 0.03 -0.82 -0.90***
Nifty India Consumption -0.1 -0.93 -0.83**
Nifty Realty -0.2 -1.01 -0.81**
Nifty Private Bank 0.01 -0.73 -0.74**
Nifty Bank -0.01 -0.5 -0.49*
Nifty Metal 0.2 -0.14 -0.34
Nifty PSE Bank -0.1 0.14 0.24**
Note: The data has been collected from NSE India website. *, ** and *** denote statistical significance at 10% , 5% and 1% respectively.  This is Table 1: Difference in mean returns before and after demonetisation

Figure 1: Mean Sectoral returns pre and post demonetisation

The sectoral impact

From Table 1, it is evident that the worst hit sectors by demonetisation are automobile, consumer and the realty sector. The banking sector, on the other hand, has had a differential impact.  

The automobile sector has recorded the highest plunge in mean returns following demonetisation. More importantly, all purchases, except two-wheelers, have mandated PAN card disclosure in the automobile industry. This had allowed cash transactions for buying two wheelers. With demonetisation, a reduction in cash transactions has restrained the demand for two-wheelers and has had a short run adverse impact on the industry. Secondly, luxury car segments have been a safe haven for spending unaccounted money. With demonetisation and massive withdrawal of money in circulation, the sector is likely to have a significant impact, with the resultant impact being seen in the index.

Consumption and FMCG

Table 1 indicates that Nifty India Consumption Index witnessed a decline of 0.86% after demonetisation. A subset of the Nifty India Consumption Index, FMCG (Fast moving consumer goods) has reduced by almost 1% post demonetisation. The Nifty India Consumption Index is designed to reflect the behaviour of sectors such as consumer durables, healthcare, auto, hotels and so on. The sudden drop in money supply and increased incidence of deposits have had an adverse effect on consumption in the economy. This sudden demand reduction further leads to a multiplier effect due to decline in consumer confidence. With consumers preferring to hold cash in hand, consumers will stick to purchasing necessities and postpone/cancel buying premium FMCG products. Similarly, producers will curb production in order to avoid stock pile up. Both these channels have hampered the sector.

The mean return of realty sector post demonetisation is 0.81% lower than pre demonetisation period. Property is another dominant route for storing black money. This coupled with a multilayered tax system (Stamp duty and registration charges, VAT and Service Tax), the sale price of properties is generally higher than the documented price. Besides, the incidence of property undervaluation is very high in secondary markets. Demonetisation may navigate this sector to a more organised system. However, the short-term reduced volumes in resale market and reduced demand has put downward pressure on land prices.

Banking sector upside

Despite the wide ambiguity on the effects of demonetisation in the economy, one opinion that is unanimous in the country is its positive influence on the banking sector. With a rise in deposits both for current and savings accounts and falling interest rates, demonetisation is expected to spur liquidity and treasury gains. However, Table 1 indicates that the average post demonetisation returns for the banking sector is 0.49% less than the return before demonetisation. Does this imply that the banking sector has in fact been hurt due to demonetisation? This requires segregating the sector into the public and private segments.

We see that the public banking sector recorded a higher average return of the order of 0.24% post demonetisation. This rise could be attributed to the fact that public banks have a major share (approximately 80% as of March 2016) in Jan Dhan Yojna accounts. With the old Rs 500 and Rs 1000 notes becoming invalid, these accounts and hence the public sector banks may witness a huge inflow of deposits. The private banking sector, in contrast, witnessed negative impact, a drop of 0.74% due to demonetisation. One possible reason may be that due to the intertwined structure of various sectors with banking, the peril impact of demonetisation on sectors as real estate, automobiles and consumption (see Figure 1) has percolated to the banking (private) sector. 

However, the public sector banks, cushioned by soft budget constraints and financial backing by the government during adverse times, are protected from this spillover effect. Another reason for the opposite effect across the two banking segments may be due to the base effect for public banks since the profitability of public banks is one-fourth of the private banks. To summarise, although public sector banks have reflected positive returns post demonetisation, the effect is not strong enough to offset the negative impact on the private banking sector.

Adverse impact likely

Average returns on most sectors that have been discussed have exhibited negative values. Public sector banking segment is the only segment that has recorded a rise in returns. The positive market sentiment associated with public sector banks may also be due to the initiative taken by this segment in the planning and execution of recalibration after the private banks bowed out.

The role of cash transactions in an informal economy is critical. With 86% of the monetary base being washed off, economic activity in the short run is likely to be adversely impacted. The wide spread negative returns across sectors after demonetisation reflect the immediate negative sentiments attached with the overall economic activity. However, with Jean Dréze calling demonetisation a big gamble for India, the possibility of a favourable outcome cannot be ruled out. The possibility of these effects being temporary may seem to be a ray of hope.

Ritika Jain is an assistant professor at Centre for Development Studies, Trivandrum.

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