Impact of IT job losses on Indian Economy

IT industry is going through a rough phase. Blame in on Trump or Brexit or Automation, jobs are being lost in this sector. They were high paid jobs in comparison to others sectors and these employees were earning forex. So the impact would be substantial. Let us try to estimate what would be the impact of this on Indian Economy.

1. Job losses: Estimates show that there are 48 lakh employees work in IT industry. Regarding job cuts, every report has their own numbers ranging from 2 lakhs to 10 lakhs. But most seem to agree that there will be around 5 lakh jobs being lost. Many senior management jobs which get top salary are cut along with the jobs at lower end being lost to automation. If we assume that average pay of these employees is Rs. 10 lakh per annum (since it includes highly paid management jobs), it will amount to USD $7.8B (billions) of total lost income per year. The actual impact could be less as many of these people are likely to find another job, may be with a lesser pay. But we need to make an estimate, so we will assume the worst case impact, and we get this $7.8B figure.

2. Reduced pay: Those who remain in the job face lots of heat too. Their variable pay or bonus whatever you call it, can be trimmed and IT companies will not shy out from doing this as we have learnt from the last downturn. If we assume that around 20 lakh (out of those 43 lakhs remaining on job) lose around 10% pay, it will sum up to $3.1B.

3. Secondary impact: As those losing their income reduce their spend on eating out, travel, etc. and also free up office space, reduce load on facilities and utility services etc. it will lead to reduced spend on services and it will have a negative impact on national income (GDP). I assume that would be equivalent to number of jobs being lost (5 lakhs) but at reduced pay. This would amount to $3.8B.

All this will sum up to close to $15B.

For Indian economy, which is around $2 trillion, $15B is not a huge impact. And on the economy growth rate of 7%, the negative impact is almost negligible as it is spread out over 2-3 years. But yet, this will kill the optimism in the industry and also reduces the employee morale which is intangible. And for cities like Bangalore where IT industry has significant presence, it may feel like recession.

If the estimated job losses begin to go up 3x or 4x, then it will start hurting the Indian economy. That no one is predicting now and probably we should not worry about. But for this down wave in IT, Indian economy is likely to digest and move forward.

Arbitrage trades and their impact on spot market pricing

Here is the textbook definition of how Arbitrage Funds earn money: “Arbitrage fund leverages the price differential in the cash and derivatives market to generate returns. The fund simultaneously buy shares in the cash segment and sell futures in the derivatives segment of the same company as long as the futures are trading at a reasonable premium.”

This would mean they do no-risk trades. Though there would be transactions costs (may be taxes as well), this arbitrage would still generate positive return with a very high probability. This opportunity exists as long as premiums on futures remain high creating a spread between spot price and its futures.

First we need to ask why there is a premium on the futures. Because there is a hope that underlying stock would gain, buyers of Futures are willing to pay a premium. But at the expiry, hope meets reality and the spot price converges with futures price resulting the premium to become zero. This cycle repeats every month.

Beginning of the new series as the premium is high, these funds enter the trade and when there is no premium to earn (at expiry or before), these trades end with square-off in futures and selling in cash market. They would earn at least 1-2% month per trade.

It is good for Arbitrage funds. But for rest of the traders, these trades might give false impressions of what is happening. As those funds buy in the sport market, demand goes up so will be the spot price. But they are creating a short position in futures market simultaneously. When they want to square-off the derivative they hold, they sell in spot market which causes pressure and the spot price declines. So this creates a price range and within that a stock would move multiple times.

Source: Moneycontrol.com

You might think all of the trades in the spot market are not arbitrage trades. Looking at the data shows that majority of the trades are indeed done by these arbitrage funds. They contribute significantly to the volume. Take example of IDFC Bank stock. The number of shares owned by Arbitrage funds in this stock is a lot higher than long term mutual funds hold and also higher than its daily or monthly average trade volume in the spot market. These funds are not long term investors but only interested in pocketing the premium and they do not care about the underlying direction of the stock. Since they would win anyway, they do not shy to create a stampede while selling or would not mind to create a hysteric demand taking the price up and increasing the arbitrage opportunities for themselves.

When they are buying, price levels see an increase beyond what it would be possible if these arbitrage funds were not present. Once their trades are set, they stop buying and the price drops as demand drops too. At this stage, arbitrage funds might decide buying again increasing the Open Interest levels or they can square-off exiting spot market too. And in the process they would damage the price to an extent of 1% to 10% depending on the depth of the market. But the fall won't be forever as they need to create hope for buyers to pay a premium which would happen with fresh buying. That is to sell futures at higher premium. This cycle repeats at least once a month and sometimes more within a month.

When a stock (traded in F&O) sees a sharp up move and then just passes time for the rest of the month, you know now who profits from it. Now that we are aware of their presence, how do we get to know their actions and how we can profit from it? I would write about that in a future blog post.

Income from your investments

Lots of us have bad experiences investing in the stock markets directly so would prefer the route of Mutual Funds. That is fine. The only problem I see is, Mutual Funds are skewed towards companies with higher market capital. That is to balance the risk-reward profile. As the assets of the fund grow, they find it difficult to earn higher returns than the index as their portfolio gets wider too. And each fund house has their own bias too. That is counter-productive. So all of this will lead to returns generated by mutual fund is almost comparable to index. Stock concentration gives higher returns than the market but can increase risk profile too. Is there a way, individual investors can manage their portfolio risks? Yes, if we can harness our emotions and invest with a sane mind.

o Have realistic expectations: We want to earn higher returns than benchmark index but we do not aim at windfall gains. Higher expectations makes us take higher risks and increase the chances of losing out. Capital protection is as important as growth.

o Give time: Think of portfolio creation like constructing a building. You cannot have rental income from a building which is not complete and it may take many months to years to complete and until then you are not expecting a return. And you are not judging the valuation of the building on daily or monthly basis during that period.

o Due diligence: Choose stocks wisely. Identifying fundamentally good stock with growth potential is a primary filter. Revenue and earnings growth have to be consistent and any deviation should have valid reasons. Risks in balance sheet should not be unhealthy. Cash flows have to be sensible and should triangulate with the state of business. Strategy as explained in investor presentations, conference calls, public interviews by the management should invoke confidence. Look at co-investors through share-holding pattern. Before you put money, spend time studying the company, their business, products, customers and competitors. The more time you invest here, higher is the quality of your portfolio.

o Techincals: Learn to identify supports and resistances. You may use chart patterns or look at option-chains or any other technical tools. Buy only at support levels. This will give a good start. If the stock falls after you buy and hits the stop-loss, it is better to get out. You did not study it well or you could not get the rhythm of that stock. Averaging it would potentially become a trap. Journey has to begin positively. Cut your losses at the first instance and retain those you get it right.

o Add only when there is price difference (and not every month): Do not buy in bulk but invest in small amounts. You will buy the next lot only when the stock moves up significantly and not periodically. If a stock stays at same level for months, there is no point in investing in it every month. We do not know the next move, it could be break-out or break-down. We are in the stock market to earn money which comes with price difference. Unless the positive price difference comes, it does not make sense to put additional money in the same stock. You may lose out on the initial rise if stock does well immediately after your purchase because your volumes were not high but you also avoided big loss potential too.

o Keep moving the stop loss level up:  This is to safeguard your profits. Since you have added more quantity only when the stock has moved up, there is a positive difference between your average price and the current market price. There is a always cushion of profits for your portfolio. But when the fundamentals change and you decide to exit, you should do so without incurring losses. Revising the stop loss levels up helps us to retain profits and realize them.

o Portfolio mix: We do not want to hold 50-100 stocks in our portfolio but wish to have around 10 stocks any given time. These stocks should not be from the same sector (for example, all should not be banking stocks or cement stocks). Ensure they are un-related, that would reduce industry risk. If regulator or the Govt. makes any policy changes, it should reduce the impact on the portfolio if the mix is not concentrated.

o Keep good cash: Keep some-thing like 30-40% of your portfolio in cash (it could be in the form of deposits or bonds or demat gold). Since stock markets surprise us often and give discount buying opportunities, we need to have cash (or equivalent) to make use of the opportunity. During your portfolio building years, you would not invest more than 70% of your money in equity. Once it begins to perform, you would book profits regularly to keep the cash levels at 30-40%. This may not look like efficient when the going is good but when there are shocks to market, the discount buying opportunities produce higher returns, this would give you an upper hand in the overall returns of the portfolio.

If you study the points listed above, we are doing everything right from identifying the quality stock, to entering at the right price, to managing the risks (credit risks, industry risks, portfolio risks) and also making good use of the opportunities.

If are too enthusiastic, you are likely to lose the money in the market so invest enough time until the euphoria is replaced with balanced perspectives. Then your investments will begin to produce positive cash flows. This journey will take at least five years. And you don’t learn to manage any business efficiently in lesser time than that.

Stock Holding Patterns and their impact on pricing

In the Short term the market is a voting machine, but in the long run it is a weighing machine.
- Benjamin Graham in “The Intelligent Investor”

We all agree with legendary Benjamin Graham. But have you thought how the transformation of scale happens with transit of time?

Every business has multiple class of investors.

1. Promoters: They form the base, they might be at the forefront of running the business or passively influencing it but they do define the ethics, value and culture of the business. Mission and Vision is defined by them. All the successful companies will have promoters with great business sense & skills contributing towards the business they are promoting. Increase or decrease in holding of promoter share would change the direction of company’s value too.

2. Growth Investors: They may not be actively participating in how the business is run but they firmly believe in the business they have invested in. They are aware of business-cycles and ignore the short-term fluctuations. They would be happy getting dividends rather than cashing out their stocks. They are in perfect alignment with promoters in the ideology and likely to hold the stocks for really longer times, if not forever.

3. Value Investors: Whenever a stock is under priced, these kind of investors will step-in and hold until their target is achieved. (They might short sell when a stock is overpriced too). Their holding period would be typically range from a few months to couple of years. They are more of a theme based investors and are in play with an expectation, so they would make the difference (profit or loss) for their expectations and sell out.

4. Short term traders: These provide liquidity to the stock. They holding period could be few minutes (algo-trading) or as long as few weeks. They would get out for very small gains or losses and would move to other counters quickly. Stocks just pass through these hands when expectations are high so there is momentum for the stock. As they get out volatility gets reduced too.


Promoters and growth investors bring in stability to pricing, their increase in holding may be an indication that stock has growth potential and is not overpriced. They reducing their stake would be an alarm. Retail investors, as shown in the history, usually come when the stock is topping out. They do not have long pockets and are not equipped emotionally to handle the stress, so they are unlikely to take the price up further steeply. That would leave the value investors which are mostly mutual-funds, big-institutions (like LIC), foreign investors and high net worth individuals. They make the most out of the market in the medium term. They have access to information, they have the buying and holding power, so can move or break a stock. But how will you know who is coming in and going out?

Promoters and large investors have to declare their trading to exchange, that information would be available to public in a day or two. But remember their moves either indicate the floor price or a high (if selling) but not necessarily the momentum which is mostly driven by value investors. To know what they are doing, look at the stock holding pattern which is published on monthly basis. If mutual funds, FII are increasing their stakes, they would not be in a hurry to sell out, they would be in the stock to get some 30-50% returns at least. Become a co-investor with them, you would be able to ride the wave.

It is presumed that you would have done your research like studying the financial statements, estimating the expected earnings growth and the risks to it. If that is all convincing, get to know the promoter and the management better. Pay attention to what the management told in their quarterly calls, investor conferences or their public appearances through interviews to media. Observe if there is a positive change and quantify that in your model. And wait for the value investors to come-in, this is for the confirmation on your research and also for timing of the entry. You would behave no differently than a fund manager but your portfolio could be better (or not) than theirs. If you have done this well, assets under your management would have grown and you have honed your skills as an active investor.

If this seems lots of work, yes it is. Investing is a serious business. If you do not have time or not serious with your investments, you are better off hiring a fund manager (invest through mutual funds and not stocks directly). But if you can pull this off, it would change your fortunes. (I am still having a day job and have not made any serious money yet from markets but slowly getting the confidence to say this.)

Bollywood, Cricket and GST

Going by recorded history, it was King Ashoka who had ruled over entire India. After him, there was no other king to match him for the geography under his command. Even the Great Mughals did not venture into south or north east. After a gap of roughly 2000 years of Ashoka’s rule, the British took India under their rule. They unified India to make it easy for them to administer. They built long rail roads and postal network to run their machinery. But that helped none other than M K Gandhi. He traveled by train mostly to all corners of India asking people to unite against a common enemy and fight for their freedom. People wrote to him addressing “M K Gandhi, wherever he is” and it was the job of postal network to locate him and deliver the mails. An idea of independent and democratic India was born and propagated using the infrastructure built by the British. After the independence, it was Mr. Patel played an instrumental role in shaping the geography of modern India, we owe map of India to him. Then Bollywood took over the job of keeping India united. The movie titles such as Raj Kapoor’s ‘Jis Desh Me Ganga Behti Hai’ to multi-starrer ‘Amar-Akbar-Anthony’, touched the underlying strings of united India. When P T Usha won the medal and Kapil Dev’s team won the world-cup for India, we all took pride in being Indians. Now Virat Kohli is not just a cricketer for us but a representative of Indian pride too. Last decade’s movies like ‘Lagaan’, ‘Chak De’ and the most recent ‘Dangal’ turned out to be block-buster successes as they were built on the theme of national pride and the motivation to fight against the odds. Though the heroes of these movies do not seem to be understanding what they stood for in their movies, the collective efforts of movie makers evoked the the right feelings in Indians. Thus, Sports and Bollywood have played a very important role in guarding the emotional sense of feeling the national pride.

As the baby boomers are aging and the new generation millennials are taking over, what would help us Indians in remaining united? First is migration across states. There are people from Punjab and North East who have found a home in Bangalore. Similarly lots of Mangaloreans are in Mumbai and Keralites have found to be far reaching and many more such instances. These migrants know the importance of inter-dependence across states and if their home state want to go separate, they would vote against it. But the in-equalities have to be reduced in the first place to avoid any such urges. Goa and New Delhi pay out the best wages in the country but those in Bengal or Orissa earn a fraction of what other Indians earn. This gap has to be bridged. Economic growth should spread and create a homogeneous India. And a step towards that will be played out by the tax reform GST. Central Govt. will collect a uniform tax from entire India and distribute the share to state Govt’s. This will avoid some state Govt.’s giving huge incentives and other states levying hefty state taxes. As the tax benefits or impact across states neutralize, focus moves on to labor rates. Those states with lower wages are likely to attract investments in the future, so job creation & economic growth spreads to under developed regions of India. Infrastructure too follows along with it. There comes a better India, with playing ground being leveled. Then Bollywood and Cricket will find some weight being lifted off their shoulders.

Digged for Gold but got Copper

We came to know that Modi can take bold and tough decisions. But political mastery does not necessarily equate with mastery over economics. So the benefits of demonetization were overestimated and the inconveniences were underestimated by his close aides. And they had to learn hard way that poor execution can spoil a good strategy. Newly printed Rs.2,000 notes became an exchange for black money and created a large scale corruption. It proved that the majority of Indians are not ready to pay taxes they owe to the system.

Let us look at the negative effects first. Take a glance at credit growth rates, it shows that it has gone to 50 years low. Bad times for banks. Vehicle sales have plummeted. Construction industry is seeing a set back. What India badly needs is job creation but the jobs are being lost as the mass employing sector like construction is seeing a set-back. You think it is a temporary phenomenon, well, it is difficult to estimate when the turnaround will come. Forget growth, going back to past levels of valuation will take couple of years for the real estate industry, so there is not much motivation for investors.

There are many positives too. Interest rates are down, inflation is under check. Money in banking system has gone up. Cash to GDP ratio is reduced. Tax collections will see an upside. Indians learnt to use Paytm. Debit cards are not limited to withdraw cash at ATM’s and consumers as well as retailers are demanding for use of POS machines. All these will help offset the negative impacts over few years period. Unless monetary system is tampered again, India would absorb this shock and post higher growth rates.

Collectively, over a period of years, benefits may over weigh the injuries done by the demonetization. But the expectations were set very high that India would be clean in 50 days, which was quite unrealistic.They digged for Gold but what they found was Copper. It too has some value.

Rich will lose wealth and Poor will lose jobs

Debates on the effects of demonetization dominate every kind of media. Economists are rolling out all kinds of numbers from -0.25% to -3.5% of GDP growth slow down. While no one questions the intentions of this master stroke but the effectiveness of its implementation is where the opinions are divided. Look at following points and then you can form your opinions.

Time to Digtial Economy: This may look good as a slogan but do you know how much is the penetration of Internet and Smart Phones in our economy to go cashless? How will those living below the poverty line buy a smart phone and get a data pack to use mobile phone as their wallet? We do not have consistent power supply in many villages and when it rains, the mobile towers do not function for days. When villagers are struggling to get clean drinking water and primary health facilities, going for a cashless system will force them to migrate to towns but the cost of living in towns and the availability of jobs would put them into helpless situations for a long time to come. Our former PM Man Mohan Singh reminded us ‘In the long term, we all will be dead’. Yes, both the poor and rich, all of us die in the long term. But this move will likely make the poor move closer to their death prematurely. Short term impact can really be devastating. If the situation is not handled well, the same people who hail Modi now will begin to criticize him.

Self-Defeating mechanism kicks in: When Real Estate transactions reduce, construction activity reduces which employs unskilled labor in big numbers. And the consumption of Cement and Steel would come down. That would mean the mining activity will also see a slowdown. What will happen to the new investments in these sectors? How about the new jobs which were supposed to be created in these sectors? Automobile industry is cutting down their production levels. If the situation continues for some more time, how much will be the job loss resulting from it? When GDP growth begins to slow and deflation begins to hurt, rich will lose their wealth and poor will lose their jobs.

Pressure on banking system increases: We thought liquidity will drive down the interest rates but RBI has a different plan. It sucked out the liquidity, may be for a good reason. But this will push out the timing to reduce lending rates for banks. When the revenues are going down, profits will slide at a higher pace and this will put a dent on many companies ability to service their loans. Bad loans will raise again. Most of the existing bad loans are in Infrastructure space and that sector will see a significant headwind (as demand for cement, steel drops), so the pressure on banking system will intensify.

If relief measures (such as reducing taxes) are brought in, it may compensate for the damage partially but how soon they will roll it out and what would be the magnitude of it is not known yet. But the long queues at Banks show the struggle for a common man to get the cash to spend on the necessities. The behavior of Indian is going to change for sure, but will it be for good? It depends on further steps the Govt. will take. Acid test has begun for them. If they cannot manage it, they will learn a big lesson themselves despite good intentions.

The new divide: Bankable vs Non-Bankable

Demonetization is going to reduce the cash-supply in the system and force most of India’s population to use the banking system. This would impact the sectors where cash was used most – Real Estate. But real estate is a broad asset class of Agricultural, Industrial, Commercial and Residential. Valuation is different for these segments and all of them do not use the same cash level when they change hands. Take a look at this map. Agriculture is the segment where cash was used most in comparison to others. So when cash crunch begins to hurt, it is likely to hurt the segment which was heavily dependent on cash.

Housing prices will see lower impact as cash component is less and it is mostly bankable (can get loans). As the interest rates begin to drop, affordability starts cutting through lower income levels which has higher population. Any price erosion along with interest drop will see demand increasing at a faster pace so prices would stop from falling further and begin to reverse in a few months period.

After a few years from now, you will see that real estate assets having changed hands into the people who were bankable, who could raise loans. If you had paid your taxes promptly, there will be lots of opportunities knocking on your door to own some real estate in the near future. And don’t hesitate as India’s growth story remains firm.

Fundamental valuation of a stock

The following diagram summarizes the components of valuating a stock fundamentally. While most of us just concentrate on the Income statement, there is a need to go one level down and understand what influences those sub-components and their trajectory.

The difficult part is in guaging the P/E multiple. Whatever numbers we come up with for earnings growth rate are just estimates as we are trying to predict the future. We need to understand the company, its products, competitors, new developments in the sector etc. to get a reasonable estimate.

If we stick to the companies whose business we understand better, this valuation exercise might become a possible task and help us know if the stock is reasonably valued or is it under priced or otherwise. That will help us identify buying and selling ranges. These estimate ranges can be honed with experience. Rather than timing the market, if we focus on price levels, we might get lucky not just once but again and again as our portfolio performs better than market average.

Real reform lies elsewhere

A person’s wealth could be much more than his annual income. Similarly a nation’s wealth is much more than it’s annual income or GDP. And black wealth (acquired through black money) is multiple times the black money in cash. Cash supply in the system is at 12% of GDP (not national wealth). In the previous blog post, we have seen that the money to become scrap could be around 10% of cash supply. That means only 1% of GDP which is in the form of black money in cash is going to be destroyed. Well, that is very little achievement. So I feel banning of Rs.500 and 1,000 currencies is more of a tax reform rather than a blow on black money.

All the black money will not remain in cash. All the cash in higher denomination is not black money either. Let us evaluate the first sentence – all of black money will not remain in cash. It is because those acquired it will spend it. They go shopping, they travel and that money comes back to circulation. But the majority of that money ends up with three things: Gold, Real Estate and Private Finance. Be it a corrupt official in a key position or a mining baron, they would convert their black money into real assets over a period of time. Else real estate prices would not have become unreal. And a portion of that money gets into private finance business too. It is black money in the hands of lenders but what about borrowers? Think of a vegetable vendor, who borrows to run his or her micro-enterprise. While I am not sure about the legality, it is not immoral to borrow to earn a living. After all, money does not have a color to classify but it is who holds it matter. So those who lent money in the denominations of Rs.500 and 1,000 bills will escape from the recent action. Their money will be promptly repaid with new currency bills over a period of time. Now what is the color of that money?  So banning the currency notes cannot deliver a serious blow to black money. Then, what can be done? Here are my thoughts:

o   Limit Gold buying and selling to a determined quantity per person per year and make the ID proof (PAN/Aadhar) mandatory to track the transactions. This will help reduce Gold import and fix our trade deficit while it acts as a check on alternate money. Super rich will be annoyed but anyway their eyes are already red. Anyone willing to buy more than the fixed quantity should be made to declare their income source and ensure relevant taxes are paid.

o   Reduce the gap between guidance value and the market value during property registration. Introduce TDS for capital gains making the transaction through banks mandatory. This would be a real check against the interests of black money.

o   Kill the private finance industry by deepening the banking reach and by providing short term capital for small vendors. Though it is easier said than done, it is a necessary step to stop the black money coming back into circulation.

All these ideas are about stopping the black money coming back to circulation but how about killing it at the source? How about firing the corrupt officials in mass, cancelling the licenses of illegal entities and making more checks before PSU banks lend to the likes of Vijay Mallya? For sure, real reform does not lie in banning high denomination currencies. There are ample opportunities elsewhere. Hope and wish they would come into action sooner than later.

The corrupt machinery has been caught off-guard now and I hope that tightening continues to trigger a reversal of black money mechanism. We need not be sympathetic towards those who are losing out their wealth now. We have already paid a price for it in the form of inflation. Tables are turning, thanks to courageous Prime Minister. Let us make India great.

How much cash will really become scrap?

Long queues at Banks tell the story of changing India. At the same time, the impact from the move seems to be exaggerated too. I formed that opinion after creating the following decision tree. Take a look:

First of all, all the cash in supply is not with the public. A major share is in banks and a good amount of money is with corporate in the form of working capital and Utilities companies too are sitting on cash in the form of customer receipts. It is all unaffected by the move to ban Rs.500 and Rs. 1000 notes.

Let us come to Public holding. Salaried people have already paid tax through TDS, so they do not have issue getting the cash on hand converted. The low wage labors are unlikely to have more than Rs.2.5 lakh cash on hand per person. If they don’t have a bank account, they will get one and the cash will be converted too. Their money is unaffected.

Then we have self-employed people like Doctors, Film actors and people in many other such professions, some of them earn handsome pay while others just earn a comfortable living. These people receive their earning mostly through cash payments and if they had remained on cash, they would be in trouble. And if that money is less than Rs.10 lakhs, they will likely declare it, pay tax and rest of the money goes back to their pockets. Few celebrities may lose good money but they are very few. But yes, some of them will have to part at least with their cash.

Small businesses, like the neighborhood grocery shop keeper, who mostly operated on cash, will face serious troubles. But they can do damage control by depositing their money in the family member’s names, paying advance salaries, settling dues etc. Yet, they are the one to lose considerable money. They looked street smart until now but now their fate has changed for bad.

The real trouble is for the people in the cash-heavy businesses. They are going to lose significant cash wealth. Real Estate looked as a promising business for them but now the rules have changed. But the challenge is to know how much cash is with them.

While the data for distribution of cash is not publicly available, we can do some guess work to get an estimate. Majority of it is likely to be with Banks and utility and service provider companies which is perfect legal and valid. If we assume 1/3 rd of the cash remains with public and half of may be on its way to become scrap. Let us put this into equation:

Scrap Money = % of Rs.500 and 1,000 bills x % with public x % of likely scrap

= 87% x 33% x 50%

= 14.35%

Since this is all guess work, actual numbers might vary. But if my guess work holds good, actual cash to be destroyed will be in the range of 10% to 15% of total cash in the system. It is still huge money but rumors say it would be in the range of 30% and that seems overrated to me.

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.

Money: The zero sum game and the cycles of money distribution

Let us say, cash supply in a system in constant. Then if one person has to become richer, it will be at other people’s expense as it becomes a zero sum game. More money one person accumulates is the outflow from the rest.

But in the practical world, money supply increases every year. But inflation too catches up. Let us say money supply got increased from 100 units to 105. And also assume that inflation too went up by 5%. In such a scenario, 5 units of newly printed money helped to increase the monetary transactions but due to inflation, it’s buying power went down so there was no increase in value of money. In another words, 105 units of money has the same value of 100 units of money in the previous year. With this background, if one has to increase his or her wealth, still it would be at other’s expense. We can also say that whoever makes most of the newly created money will become richer. If one still has the same amount of money he had last year, he lost it to winner through inflation.

Now we need to explore how the money is earned. Broadly two classes are present. Majority of world’s population earns through labor, in the form of wages or salary. Other smaller segment put their capital to work. Profits or interest earned on that is their income or way to make money.

Now, it is time to introduce interest rates and wage growth rates. Every year new money is created. And if wage growth rate is more than interest rate, then the labor class gets more portion of that new money. If rates are higher than wage growth, then it is capitalists who will make more money than labor class. But that is not all, we cannot forget the impact of inflation, so we need to look at the real rates of growth.

Real Interest rate = Nominal Interest Rate – Inflation

Real Wage growth rate = Nominal wage growth rate - Inflation

These equations will decide if rich are becoming richer or the rich-poor gap is getting closed. Let us say interest rates are at 6% and inflation too is at 6% but wage growth rate is 7%, you know that capitalists could not increase their wealth in that year and the labor class made most of the newly created money. But it is not like that same all the time. Most of the times real interest rates are positive and will be higher than the real wage growth rates, that gives an advantage to capitalists. Their money works for them, throughout their lives. So you know how the system helps  rich to remain in top positions for decades unless they make some blunder mistakes losing out their wealth.

But the interesting point is, interest rates are common across market but the wage rates are not. There are many professionals (like in IT industry) whose pay checks showed higher growth than that of interest rates. They are able to reduce the gap with capitalists. Or they might become new capitalists if they learn the tricks of savings and investing. So we find many Merc’s and Audi’s on our roads and they do not belong to Tata or Birla families.

Coming to the common man, if his earning growth is better than inflation rate, he is getting ahead. If it is same, he is just catching up with the transformation. But those earning less are losing out to the winners of the race. If one wishes to get out of labor class, savings and re-investments are the keys. If one person earns a handsome salary but spends it all, he is no better than daily wage labor in the long run despite the high lifestyle he could afford in the earning years.

When you read an article of rich becoming richer, take a look at difference between interest rates and wage growth rates, you will know how the money got distributed for such an outcome. Though it is happening everyday in front of our eyes, we do not realize it and wonder what’s happening in this world. Well, nothing dramatic but very systematic.

Deficits = Increase in Money Supply = Inflation Rate (India’s macroeconomics)

Though I studied Economics as a subject in my MBA and have read several books on the subject of Macro-economics, it took a while for me to figure out the equation, well suited for India’s macroeconomics. 

Deficits = Increase in Money Supply = Inflation. 

This is an approximate estimate and not a perfect match in numbers. Objective is to show that they influence each other. Deficit is the cause, increase in money supply is the means and rising inflation is the result.

It is the twin deficits (fiscal deficit and current account deficit) at the root which will demand an increase in money supply which will result in inflation. If you look at text book definitions, they would explain things academically but I would like to provide a different perspective on how these are interrelated.

Responsibility of managing fiscal deficit lies with Govt. And no Govt. borrows the money directly from their central banks. But this is what happens:

Fiscal Deficit Cash Flow:

o   Govt. needs excess money (deficit) to spend than its income (taxes, other incomes). It borrows from banks and public issuing bonds.

o   When bonds reach maturity phase, central bank (RBI) buys it from banks with the newly printed money. It expands its balance sheet (increases M3 Money Supply). Banks get cash for swapping the bonds.

o   Govt. borrows again from banks and newly printed money is used to fund deficit spending.

Current Account Deficit Cash Flow:

o   Trade Deficit: Difference in trade account balance resulting in international trade (India’s imports are higher than exports so there is a trade deficit)

o   Capital Flows: India sees inward cash flows through remittances, FDI etc. There is outflow too. Though this is positive, it is not big enough to pay for trade deficit.

o   Resulting deficit (negative trade balance and lesser positive cash flow) has to be funded. Businesses borrow from banks which in turn borrows from RBI. There is expansion of balance sheet in the central bank again.

These twin deficits put together will ask for new money creation and the inflation catches up with it. To check if my hypothesis holds true, let us look at data.

Year	Fiscal Deficit % of GDP	Current Account Deficit %	Both Deficits %	Inflation rate %
2009	7.8%	2.8%	10.6%	10.9%
2010	6.9%	2.8%	9.7%	12.0%
2011	5.1%	4.3%	9.4%	8.9%
2012	5.8%	4.8%	10.6%	9.3%
2013	4.9%	1.7%	6.6%	10.9%
2014	4.5%	1.3%	5.8%	6.4%
2015	3.9%	1.3%	5.2%	5.9%

Yes, though numbers do not match closely, they are comparable. Since this is an approximation and not a direct measure, they would not match. Moreover, inflation has two causes, monetary causes (which is covered in this blog post) and supply side reasons (which is not scope of this post). As the objective is to establish the relationship, it would serve the purpose and it would help us in getting an idea of how different components of macro economy influence each other.

Here is another check. During 2009-2015, the total twin deficits were approximately summed up to $1 trillion. If you look at increase in M3 money supply, it is around the same. (Below chart is in INR).

After synthesizing the data and the relationships, you will wonder how the deficit funded economic growth does not change the purchasing power of consumers as inflation robs away the benefits and the currency too deflates in the process. If deficits are low or trade is surplus, there would not be much rise in inflation while economy expands and it would result in currency appreciation too, resulting in positive benefits. Present Govt. is doing a better job at it than its predecessor. But when the larger economies are having an inflation of less than 1-2%, India recording 5-6% numbers seems high. Now you know why inflation is high and who is using that newly created money. If that money had created an equivalent asset, it would not have resulted in Inflation.