Editor's note: In what people are already calling a historic move, Prime Minister Narendra Modi today announced the demonetization of Rs 500 and Rs 1000 currency notes. Deepak Kanakaraju of DigitalDeepak.com puts forth his opinion on the historic move. Please note that the copy has been reproduced as is and has not been copyedited.
First, people who have a lot of cash, legally earned, will deposit it in the bank. This will increase bank's deposits by a huge margin.
This will also increase the lending activity because banks have a CRR (cash reserve ratio) to maintain and with more deposits they can do more lending.
Credit (loans) will become easier and interest rates may come down. More loans given out increases broad money supply and creates inflation. But this will happen slowly, not over-night.
What will happen over-night is heavy deflation.
Because people who have illegally earned this money may be afraid to deposit it in a bank. There are people with crores of cash, black money, earned through illegal ways, such as corruption, smuggling etc.
Some of these guys will try to find this money into a bank, but they have to declare it as income and pay taxes on it. Then the question arises - how did they make this income in the first place. Most of these guys will chicken out, count their blessings and just waste the money they have stashed somewhere in Rs.500 and Rs.1000 notes.
This will reduce the total currency circulation in the economy - leading to deflation. Deflation increases the value of money that we have because the total money supply goes down but the commodities and things available in the market have not gone down.
[Example] If there are 100 widgets and 100 coins, each widget's value would be Rs.1. If there are 100 widgets and only 50 coins, each widget would cost Rs.0.50 only. Which means with each coin, you can buy 2 widgets.
The inflation and deflation will balance out each other on some level. But it is going to take some time for the inflation to happen because lending activities do not happen over night.
Deflation will happen first, for the next 6 months to 1 year. Gold prices will drop, stocks & commodities will drop. Everyone will get excited and congratulate the government for making this move.
Then slowly, as lending activity goes up, the broad money supply will go up and prices of all things would go up, slowly and steadily.
Now no one can predict the extent of the deflation and inflation. In an ideal world, if 100% of the people who have Rs.500 and Rs.1000 notes have it as white money, then we would see only inflation. If a lot of these are black money and if many people decide to waste the money instead of depositing it, then we will have deflation in the short term.
If you see heavy deflation and heavy drop in prices, then it means that India has a lot of corrupt people who earned money in illegal ways, too afraid to deposit the money in a bank!
And my gut feeling says that we would see heavy deflation in the next 6 months. If you bet on this, then buy gold, stocks of asset-heavy companies.
What about Real estate?
It would crash slowly and recover quickly. That's because, in real estate, there is no index price like gold and it is fixed by the market in a demand-supply balance.
Let's say I have a real estate plot - a 40 x 60 plot which I bought for 1 crore a year back. Let's the say market value of it until yesterday was 1.5 crores. I would still think that the value of it would be 1.5 crores and I wouldn't sell it for less than that.
But if I want to sell it because I need money, I wouldn't get a buyer immediately. Because most buyers in real estate are doing the transactions in black money. Potential buyers would tell me that they don't have 1.5 crores in white money, so they will not be able to buy it.
With less potential buyers in the market and fewer people having white money, the demand for the land goes down and drives down its price. If I yield and sell it for 1.2 crores, I am driving down the market price in the entire locality.
Real estate crash will happen slowly because people will yield to the pressure slowly and start selling at lower prices because suddenly the pool of potential buyers have gone down. I predict that real estate prices would dip to lowest by end of 2017 and then start moving up again as inflation catches up.
[Currencies, inflation, deflation, payments and banking is a very interesting subject for me and I have read a lot of books on this topic. This is just my opinion, but I am bold enough to share this in the public domain. However, I may be wrong. Let's see how this pans out. Today is an iconic day in India's journey. History in the making. Nov 8th 2016! This would be a day to remember.]
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)
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