Impact of the Demonetisation on Bond Markets


Late night on 08/Nov/2016, Prime Minister Shri Narendra Modi, announced the withdrawal of large-denomination banknotes (₹ 500 and ₹ 1,000) to clamp down on ‘black money’ and curb corruption. The details are:

1) Banknotes of ₹ 500 and ₹ 1,000 will cease to be legal tender on 09/Nov/2016. Such notes in circulation will have to be deposited/ exchanged at banks by the end of December 2016. While there are limits on the withdrawal of notes (₹ 20K weekly cap), there is no limit on the value of “old” ₹ 500/₹ 1,000 notes that can be deposited into an individual’s own bank account. Those unable to deposit ₹ 1,000 and ₹ 500 notes by 30/Dec/2016 can do so until 31/Mar/2017 by providing a declaration besides a proof of identity.

2) RBI will issue new high-security banknotes in denominations of ₹ 2,000 and ₹ 500 which will be put into circulation on 10/Nov/2016. Banks will be closed on 09/Nov/2016. ATMs will not work on 09/Nov/2016, and in some places not on 10/Nov/2016 either. This is to allow the transition to the new currency notes.

3) Concessions will be allowed for the use of the old currency notes for essential needs.

4) No restriction on non-cash transactions. There is no restriction on any kind of non-cash payment via check, demand draft, debit or credit card, or electronic fund transfer. This could mean that payments move more towards electronic channels over time.

Source: Nomura Economics Research

Impact on
(a) Government Finances: Fiscal Deficit is expected to improve as:

  • Integration of the black economy with the regular economy to reduce tax leakages
  • Increased transparency and compliance will bring in more people under the tax net

(b) Inflation: This move is expected to bring the prices down as:

  • Consumption (discretionary, and possibly otherwise) is likely to be negatively affected in near term bringing down the demand
  • Reduction in volume of transactions and lower currency in circulation will improve underlying inflation

(c) Growth: May slow in the next two-quarters as a luxury real estate, land prices, jewellery and consumption spending (especially on big ticket items) should correct in near term. The potential disruption to the payments system and economic activities over the coming weeks is likely to weigh on near-term sentiment & growth outlook.

Long-term Structural Change:

This move generates support for financial savings instruments – eg, bank and non-bank deposits, mutual funds, equities and bonds. A potential reduction in holdings of cash would also point to lower currency ’leakage’ from the banking system. Clubbed with GST, this move will have far-reaching impact on bringing parallel economy to mainstream economy thus giving a further boost to India’s GDP & Improve inflation outlook.

Impact on bond markets:

(a) Increased Liquidity:

  • Banks are expected to receive significant deposits from individuals and corporations until 30/Dec/2016. This will lead to a sharp buildup in bank’s deposit base during this period.
  • Normally, the second half of the financial year sees significant demand for a physical currency due to pick-up in business activity. This seasonal phenomenon is expected to be significantly muted due to restrictions placed on cash withdrawals.

(b) Higher demand for government bonds: This improvement in banking system liquidity will result in downward movement in bank deposit rates and lead to increased demand for SLR securities (government bonds).

(c) Lower Rates: We expect rates at the short end to be structurally lower and the newly created liquidity to spur demand for investment opportunities in the bond markets making short-term, medium-term and long-term mutual funds, an attractive investment option.

Near-term market moving events

  • CPI (15/Nov): Expectations are sub 4%
  • FED (15/Dec): Prospects of a Fed December rate hike have declined to 50% on the back of recent US election results

Source:  DSP BlackRock Investment Managers Pvt. Ltd. AMC.
In this material, DSP BlackRock Investment Managers Pvt. Ltd. (the AMC) has used information that is publicly available, including information developed in-house. Information gathered and used in this material is believed to be from reliable sources. The AMC, however, does not warrant the accuracy, reasonableness and/or completeness of any information. The data/statistics are given to explain general market trends in the securities market, it should not be construed as any research report/research recommendation. This is a generic update on Fixed Income and Equity Market; it shall not constitute any offer to sell or solicitation of an offer to buy units of any of the Schemes of the DSP BlackRock Mutual Fund. We have included statements/opinions / recommendations in this document, which contain words, or phrases such as “will”, “expect”, “should”, “believe” and similar expressions or variations of such expressions that are “forward-looking statements”. Actual results may differ materially from those suggested by the forward-looking statements due to risk or uncertainties associated with our expectations with respect to, but not limited to, exposure to market risks, general economic and political conditions in India and other countries globally, which have an impact on our services and / or investments, the monetary and interest policies of India, inflation, deflation, unanticipated turbulence in interest rates, foreign exchange rates, equity prices or other rates or prices etc. All figures and other data given in this document are dated and the same may or may not be relevant in future. 

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