Paper Money Starts to Flow Again in the World's Fastest-Growing Major Economy

 | Mar 14, 2017 | 11:00 AM EDT
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Reaching the endpoint of one of the wildest experiments to drive a black-market economy above board, India on Tuesday scrapped limits on cash withdrawals from banks. Financial institutions were prepped for strong demand for paper notes as they reopened today, a day after the holiday to honor Holi, the Hindu spring festival.

Banks such as ICICI (IBN) , HDFC (HDB) and Axis Bank, listed in London under the ticker AXB, are keen to encourage cashless transactions within the banking system. So their stocks are worth a watch.

Cash rationing had been necessary after India suddenly cancelled 86% of all the cash in circulation on Nov. 8. Legal tender plunged from $253 billion to just $35 billion, according to the Financial Times. The cash pool has since expanded to $158 billion.

The administration of Prime Minister Narendra Modi shocked its citizens, and the rest of the world, by declaring the 500 rupee ($7.50) and 1,000 rupee ($15) notes useless as tender. Citizens had to deposit the notes in banks by the end of December if they wanted to hang on to their money.

However, it doesn't seem to have done any harm to Modi, who scored an emphatic vote of confidence in elections that just concluded over the weekend. The business-friendly leader's party, the BJP, won in a landslide in India's most-populous and politically important state, Uttar Pradesh, capturing more than 80% of the available seats. The BJP also gained a majority in Uttarakhand and won seats in Manipur. It did, however, lose ground in the Punjab and Goa.

The motive for demonetization was very clear. The "informal economy" makes up 45% of India's economy, and at least 80% of all transactions happen in cash. As anyone who has ever waited tables can attest, not all of those deals make their way onto what's filed with the taxman.

Declaring the most-common notes useless forced everyone in India to legitimize their cash holdings, or lose them. The demonetization absolutely had to be a total shock, to avoid black marketers translating their notes into other denominations beforehand.

The abolishment of the 500 and 1,000 rupee notes caused a massive headache for banks, and their customers. There were huge lines at banks to take out any of the tiny number of notes still in circulation. Tourists complained they basically couldn't do anything on their trips, other than wait in ATM lines.

The move also left the central Reserve Bank of India, which had also been in the dark about the move, scrambling to print enough cash. Commercial banks have prepared for the end of cash rationing by imposing fees on both deposits and withdrawals. Each is imposing a 150 rupee ($2.27) charge on the fifth cash transaction per month and beyond. 

For large transactions, HDFC will charge 0.5% on transactions of more than 200,000 rupees ($3,020), with Axis charging that on amounts above 100,000 rupees ($1,510). State-run State Bank of India, home of two-thirds of the banking system's assets and listed in London as SBID, has imposed similar duties.

Indians will undoubtedly be nervous of attracting the attention the taxman if they have deposited large amounts of cash into banks. Although bankers say Indians still favor carrying around large amounts of notes, the sudden disappearance of so many notes did force many citizens to consider online alternatives.

"What would have taken half a decade to achieve has been crunched into these few months," Ramesh Sobti, CEO of IndusInd Bank, told the FT. "The whole cash culture has been disrupted."

The restrictions on cash withdrawals by businesses were lifted at the end of January. Last month, the weekly cash withdrawal limit for individuals doubled from 24,000 ($362) to 50,000 ($755) rupees. 

I explained at the start of this month that India's economy is not showing any signs of disruption from the demonetization shock. In fact, it has suspiciously consistent gross domestic product figures for the December quarter, the first that would reflect the cash shock, stats some people simply don't believe.

Nevertheless, there's no doubt that India's growth is impressive. Asia's third-biggest economic driver, also the world's seventh-largest, is growing faster than any major economy in the world. It likely rose 7.1% in 2016, according to Oxford Economics, and should sustain a rate of more than 6.5% for at least half a decade from now.

The swift, sharp shock of demonetization will certainly have driven a share of the cashless economy above board, and into the banking system. Just how much remains there now that the restrictions on paper money are no more remains to be seen.

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