Friday, November 11, 2016

Master stroke and deflation on the way

For Indians, it was always the inflation which caused troubles. Deflation was a foreign thing for us. But the whole world is sinking into depression. Now it will be India’s turn but the reasons are different. When other central bankers are expanding their balance sheets, India is going the opposite direction. Banning Rs.500 and Rs.1000 currency notes will result in shrinking the balance sheet of RBI. It was a necessary bold step to curb black money, corruption, fake notes etc. And the impacts on the macro-economy would be as follows.

o   Drop in Interest Rates: Bank deposits and liquidity in the banking system increases (not the cash supply). This will lead to drop in interest rates both for depositors and borrowers.
o   Consumer Spending to go down: Since the unaccounted black money will disappear, cash based transactions will take a big hit. Since most transactions will happen through organized retail in the cashless economy, all of the transactions become accountable and consumers will have to pay relevant taxes. Consumers will be left with less surplus money, so their spending too will come down.
o   Widening the tax net: For the reason cited above, tax collections are set to increase. And the disappearance of a portion of black money will lead to wind-fall gains for the Govt. in this fiscal year. And that amount will be huge, may be to the tune of 30% to 50% of yearly budget of central Govt. While how the Govt. plans to spend is not known, it will lead to a situation of fiscal deficit turning into fiscal surplus this year.
o   Value of Rupee to go up against Forex, Gold and Real Estate: As Rupee is set to become a scarce commodity; its value is set to rise. Though Gold can go up momentarily for couple of months, it is likely to lose its attraction next year. Similarly lack of cash supply and absence of black money will put pressure on real estate. Same the case with forex too. While the conversion rates are also dependent upon the strength of other currency, Rupee is likely to maintain its value if it is not going to strengthen against any particularly currency. This is bad news for exporters but good news for importers.
o   Inflation to slow significantly: As cash becomes tight, and there is no need for Govt. to borrow, it means there is no need to print new money (except the replacement of existing currency notes), so inflation will come down. Both demand side and supply sides will see a drop. So forget inflation, we may have to stare at deflation.

That was the background for setting the stage for the case of deflation. Now how to handle the deflation is next part of my blog post. Since the value of cash is set to go up, you should get out of other asset classes to get onto cash. And there would be other ways too. And I suppose they are these.
o   Pre-close existing loans now and reborrow at low rates: Use cash on hand, liquidate some Gold and convert any forex you own and use the proceeds to pre-close existing loans. As rates are set to go lower, you can re-borrow at a lower rate later.
o   Avoid investing in real assets for some time: Let deflation take its course and wait for it to complete. That would take a year at least. You are likely to find the property you wished to own at a lesser price and since the interest rates will be lower, you will find it affordable to pay the EMI.
o   Economy will rebound: Though economy is rebooting now, after the initial shake-up and adjustments, it will come back to normal course probably in 2-3 years time frame. In that period, wages may go up along with GDP as money velocity is better with more money in the hands of poor and middle-class than the black money hoarders. As the Govt. will have higher tax inflows, they can use it to improve the infrastructure of the country and that will pay in the form of productivity increase. That would help wages to go up. Higher incomes and lower interest rates will keep the economy rolling at a better pace. Though it is difficult to time the changes, one can watch the economic indicators and adjust the decisions accordingly.

Modi’s Govt has given a golden opportunity and you can use it to your benefit. Don’t hurry now to get into asset classes and when things begin to turn around; don’t wait to get into them. Use the time in between to prepare for what it is needed. Clean-up your finances; improve your credit score as it will come in handy when you want to borrow big to ride the next wave of growth.