impact of demonetisation

1. IMPACT ON DEMONETISATION
According to public sector bank executives, the work pressure from managing deposits and
cash withdrawal is coming down and banks have begun to assess the impact
of demonetisation on the
loan side – both asset quality and demand for credit. Risks of slippages have
increased and a picture will be clear at the end of the financial year. Karthik Srinivasan,
senior vice-president of ICRA, said delinquencies have increased as collections have gone
down.
The loss of income has severely dented the loan repayment ability of small borrowers. Also,
many of those bankers who were deployed for loan recovery were put on the job of
managing a sudden surge in activity at branches after demonetisation. The combined effect
will be a rise in stressed loans by at least 100 basis points, said Abhishek Bhattacharya,
director and co-head (financial institutions) at India Ratings.
According to global rating agency Standard and Poor’s (S&P), many advances on banks’
watch lists could also slip due to the cash crunch and a slowdown in business. Companies
are also affected by rising working capital cycles since they have to support the supply
chain, which often deals in cash. Therefore, borrowers at the margin could turn delinquent.
Abizer Diwanji, partner and national leader (financial services) at EY India, said although
people will resume payments, it would happen with a lag. It would take a couple of quarters
before payment patterns normalise. Highly cash-dependent businesses, especially small
and medium enterprises, will have a hard time in making payment. This will push the kitty of
stressed loans.
Bank chief executives in their pre-Budget (FY18) presentation to the finance ministry said
four sectors need attention. These are: Vegetable growers who depend on cash for their
day to day dealings and can’t hold their crop for long, as it is perishable; brick-kiln labourers,
as their owners used to pay them in cash; the transport sector in rural India; and,
plantations in the South.
An IDBI Bank executive said this quarter would see a severe impact of demonetisation on
loan demand and slippages.
ICRA estimates 80-85 per cent of retail credit (of finance and housing finance companies) is
in the under Rs 1-crore loan size category. Non-banking financial companies and housing
finance companies operate largely in the self-employed borrower segment, which conducts
business mostly through cash transactions and thus is considerably affected by the
withdrawal of Rs 500 and Rs 1,000 notes.
The fallout of demonetisation will be a drop in credit growth. Advances for the banking
system are expected to grow at 10-11 per cent in FY17. Now, credit may expand at a
slower pace of 5-6 per cent, Bhattacharya said.

2. Credit offtake has already slowed drastically in the current financial year compared to FY16.
Banks disbursed Rs 89,500 crore from April to early December — down from Rs 4,03,220
crore in the same period in 2015-16, according to RBI data.
IMPACT OF DEMONETISATION
POSITIVE IMPACT:
Increase in CASA deposits for most banks; lending rates to drop further
The biggest beneficiary from this policy will be the banking sector. This is mainly due to the queues of
people depositing cash in the banks – which will result in substantial liquidity with the banks. As the
deposits with the banks will increase so will increase the CASA, which will increase the Net Interest
Income and the Net earnings of the banks. However, this will not be abnormally high since the RBI has
increased the CRR in the short term to mop up some of this liquidity.
As stated above higher CASA means large amount of deposits are in current and savings account. This
way the banks get funds at no or very low cost (interest). Banks do not pay interest on the current
account deposits and pays a very low % of interest on savings account deposits. Hence, it is a good
measure to get deposits at no or very low cost.
As the banks get a lot of liquidity in their hands, they are expected to enhance the borrowing cycle by
lending the money at a lower rate of interest. Hence, the interest rate on borrowing will lower down.
NEGATIVE IMPACT: MFIs, NBFCs miss collection cycles
NBFCs and microfinance institutions (MFIs) are under severe stress as their collection cycles (mostly in
cash) have gone awry post November 8. Most NBFCs and MFIs have announced ‘collection holidays’ till
such time there’s sufficient money in the system.
The government’s demonetization drive may puncture the earnings of most banks this quarter. With most
staffers handling the Rs 500 and Rs 1000 note deposits, exchange and withdrawals, “revenue-yielding”
operations such as vending loans and cross-selling investment products have taken a backseat in most
banks.
The earnings of banks may take a hit in the third and fourth quarter. We may not see loan book growth as
most banks are busy facilitating the demonetization process. They’re not aggressively selling a lot of
credit products now. That apart, the SME and real estate sectors, to which most banks lend a significant
part of their book – are in a state of major flux.
Temporary measures to mop up liquidity:
The Reserve Bank of India or RBI has announced incremental CRR (cash reserve ratio) of 100% on the
growth in bank deposits between 16 September 2016 and 11 November 2016. The entire incremental
deposits (~Rs3.2 Tn) in the prescribed period have to be parked with the RBI as CRR. No interest will be
paid on CRR, while banks will have to shell out ~4% interest on the funds received in savings deposits.
Not only the expected positive carry on incremental deposits has been wiped out, but there will also be a
negative carry on such deposits. The higher CRR is a temporary measure to drain liquidity in the banking
system and will be reviewed in the fortnight ending 9 December 2016 or even earlier.

3. This is a temporary measure to suck out excess liquidity in the banking system after the announcement of
demonetization by the government as banks were parking bulk of the receipts through reverse repo
window. Given the RBI’s limited capacity to accept funds under reverse repo and related interest outflow
on the same, the central bank announced parking of incremental deposits under CRR which entails no
interest outflow.
The first week since demonetization was dramatic to say the least. The rush to surrender old
notes and the limited release of new money created a huge monetary imbalance in the system.
Obviously, it will take some time for the system to self-adjust and for normalcy to be restored.
But during this period, there has been a phenomenal increase in the deposits with the banking
system. According to early estimates, the first 3 days resulted in total deposits in the banking
system going up by nearly Rs.350,000 crore of which over Rs.50,000 crore was received by SBI
alone. On the day after the demonetization announcement, we did see a sharp rise in banking
stocks. The question, therefore, is whether there is a fit case for re-rating banks. There are 3 ways
in which banks will benefit from the demonetization drive.
The surge in deposits will continue.…
Banks are likely to see a sharp rise in deposits in the coming weeks. With withdrawals restricted
and likely to continue to face limits, the banks will find themselves in a sweet spot. Banks will be
in a situation where the net growth in deposits will be really rapid. Now why is this important?
The largely cash economy was restricting the growth of deposits with banks. Most of these
deposits over the next 45 days will come in the form of current and savings account (CASA)
deposits, which means they will be low cost funds and will bring down the average cost of funds
for banks. This will have 3 very important implications. Firstly, it will allow banks to expand
their lending books as deposits growth was the key constraint. Secondly, this will have a salutary
effect on cost of funds. As we have seen earlier, most of this money will come in the form of
CASA deposits and hence the cost of overall deposits in the banking system will come down.
Lastly, as the loan book expands the NPAs as a percentage of the outstanding assets will come
down sharply. This will ensure that rate cuts are more seamlessly transmitted to the end
customer.
It will bring down the yields on bond holdings…
The surge in deposits will ensure that the banking system is flush with liquidity. We have already
seen how the surge in liquidity in the money market due to the RBI’s reverse repo operations
have brought down the yields at the short end of the yield curve. The fall in yields at the shorter
end of the yield curve will get more acute. As rate cuts are more seamlessly passed on to the end
user, the RBI will have the incentive to cut rates further and that will bring the yields at the long
end of the curve also down. The net effect will be that the overall yield curve will actually shift
downward. Now, why is this important? Firstly, the fall in yields will result in appreciation in
bond prices. Banks will directly benefit from this move as they are already holding bonds above
the 21.5% prescribed SLR limit. Secondly, as yields come down, the RBI will be in a position to
bring down the SLR further. With lower yields on bonds, banks will have no incentive to hold on
to excess government bonds in their SLR portfolio. That will mean greater off-take of loans; of

4. course hoping that the credit demand also picks up by then. That will almost be like hitting two
birds with one stone.
Banks will see an improvement in their operating margins…
Currently, Indian banks (especially the PSU banks) are suffering from low OPMs due to weak
net interest margins (NIM) and high level of NPAs. The current surge in deposits and fall in
yields will combine to change that scenario. Banks will find themselves in a situation where the
sharp increase in CASA deposits will reduce their average and incremental cost of funds
substantially. That will be combined with a pick-up in credit as investing in SLR securities will
become unviable with lower yields. Interest rates on the loan portfolio will not fall at the same
rate as the cost of deposits having a salutary impact on the NIMs. With a surge in deposits, the
average cost per client will also come down sharply and that will have its positive impact on the
operating expenses of the bank. This, of course, will also have a positive impact on the
valuations of Indian banks making a fit case for re-rating.
So, in a nutshell, this demonetization may have come as a boon for Indian banks. On the one
hand, they may see a surge in new account openings and on the other hand they are already
seeing a surge in deposits. The bigger takeaway for banks will be the improvement in their
operating margins. This could be the big moment for the Indian banking system.