How I’m trading India’s mini depression

We are at a juncture where the full extent of India’s massive demonetisation mess will be revealed as banks prepare for an assault at their physical currency holdings. After removing 87% of the circulating currency, the government is preparing to allow citizens to withdraw whatever they want in the new currency.

But is there enough physical currency? Will the money supply be kept at the same level as before? And what can we expect in terms of inflation, growth and interest rates in the near future?

On 8 November, Narendra Modi, the Indian PM, announced shocking measures to demonetise the economy, removing the legal tender status of the INR 500 (GBP 6.018) and INR 1,000 (GBP 12.035) note denominations overnight, which corresponded to around 87% of the circulating currency.


Such an attempt has almost no precedent in modern economics and is widely expected to negatively impact inflation and growth, and ultimately to create some sort of chaos, even if only temporarily. But Modi is committed to fight fraud and tax evasion, and is willing to adopt a full quiver of unconventional measures to achieve his goals.

Cash crunch

In declaring 87% of the money supply illegal, Modi thought he could force the circulating money to be converted into deposited money, tax part of it, and completely devalue the cash piles of illegal money held by those involved in illegal activities. Given the limits imposed on the money that could be deposited at once, it would be difficult for someone to wash his cash holdings into new currency without losing a significant part of it to the government.

Some of the money would likely never come back, meaning that part of the central bank liability would be written off from its balance sheet, releasing funds that could be used by the government to increase spending and help boost GDP. The limits on withdrawals could also help in forcing the population into using debit and credit cards instead of the more traditional cash payments, making it easier for the government to control economic activity in the future.

Only 32% of India’s population has access to financial institutions and banks are highly concentrated in major urban areas.

While replacing the existing money supply has its merits, such a process takes time to unfold. Only 32% of India’s population has access to financial institutions and banks are highly concentrated in major urban areas. Additionally, 60% of workers are paid in cash and there is a huge tradition of using cash in transactions.

Under these conditions, the required change isn’t an overnight process, as Modi seems to believe. Any demonetisation should occur gradually to avoid the reduction of the real money supply at all costs, because if that occurs it can have a devastating impact on GDP, in a similar fashion to what happened during the Great Depression.

Counting the cost

Almost two months after the policy was announced, it is still too soon to evaluate the economic impact of the demonetisation in terms of GDP and inflation. Only in 2017 will we have the data to evaluate it. But we already have some data regarding how much money has been returned.

When the policy was announced, the government was expecting as much as INR 5 trillion (GBP 60.2 billion) to never return to the banking system. But of the INR 15.3 trillion in circulation, more than INR 14 trillion has already entered banks’ vaults.

With these data in mind, either the government completely overestimated the size of the illegal economy or the fraudsters are becoming smarter. It’s not difficult to foresee that those with massive amounts of illegally-obtained cash would most likely convert it into gold, dollars, euros, and in particular hard assets, instead of keeping it under the mattress in rupees.

Ultimately, the difference between circulating money and returned money will be small to negligible, which means the government will be unable to conduct any significant stimulus from it. On that front at least, the demonetisation is a failure.

But my main concern about India is related to the difference between the current money supply and the old money supply. In a country where 90% of transactions are conducted through cash, deposited money and cash, while both being part of the money supply, are not really perfect substitutes.


This means that forcing the conversion of cash into deposits acts like a huge contraction of the money supply (with the money supply here seen as the actual money available for transactions). Even if banks are able to remove the withdrawal limits tomorrow, we’re not completely sure that there will be a return to the previous cash levels. Because society doesn’t change overnight, the money available for transactions will most likely be permanently reduced, which will depress nominal GDP, either through deflation or economic contraction, or possibly even both.

The Quantity Theory states that MV = PY (with M being the money supply, V the velocity of money, P the price level and Y the real GDP). V being relatively stable, the reduction in the money supply will lead to a reduction in MV, which means that it will push nominal GDP (PY) lower. Modi is creating recession and deflation.

Later developments in the Quantity Theory, in the hands of Richard Werner and his Quantity Theory of Credit, show that not only will nominal GDP decrease but also any stimulus attempt by the government will result in an adverse movement in consumption, private investment and net exports, as the economy will be bound by a lower money supply. The only uncertainty here is the exact share of the decline between prices and quantities.

More pain to come?

Despite the current mess, some expect Modi to adopt even more unconventional measures, as he elevates his crackdown on illegal activities, fraud and tax evasion. Some believe that he will target property purchased with illicit wealth and not registered in the true owner’s name, and abolish all forms of taxes to replace them with a single 2% bank transaction tax.

…one should expect Modi to adopt further measures at restricting the use of cash, which one way or another will play out as a reduction of the effective money supply.

Because this only works when the money is effectively forced into the banking system (otherwise you couldn’t tax the anonymous owned physical currency), one should expect Modi to adopt further measures at restricting the use of cash, which one way or another will play out as a reduction of the effective money supply.

During the 1990s Brazil tried to implement a banking transaction tax but eventually up because the money flew out of the banking system, leading to much higher interest rates and to an ineffective outcome.

Modi’s gambling will have a serious impact in India’s economy and I intend to stay well clear. I’m selling the Columbia India Small Cap ETF (NYSEARCA:SCIN) and Columbia India Consumer ETF (NYSEARCA:INCO). Consumer and small cap stocks are expected to suffer the most from all this.