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India's move to withdraw high-value banknotes to boost liquidity


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No disruption on the road to digitization

India's move to withdraw high-value banknotes to boost liquidity

India's decision to withdraw 3.62 trillion rupees of high-denomination banknotes will lead to a spike in liquidity as holders rush to deposit their money in banks, though the impact on the economy is likely to be minimal.

With the impact of the banknote withdrawal, bank deposit growth in India is estimated to rise to about 10.7% year over year in September from about 10.4% year over year in early May, compared to a previous baseline growth of about 10%, Nomura said in a May 21 research note. This would imply additional deposit accretion of around 1.2 trillion rupees. A rise in deposits could allow banks to lower deposit rates and reduce their reliance on wholesale funding, leading to reduced pressure on funding costs, Nomura added.

The Reserve Bank of India, in a surprise announcement May 19, said it will withdraw all 2,000-rupee notes from circulation. Holders have until Sept. 30 to deposit the currency in banks, the central bank added.

The 2000-rupee notes are being withdrawn as they were introduced in 2016 to meet the currency requirements of the economy after the 500- and 1000-rupee notes were voided in 2016. About 89% of the 2000-rupee notes were issued before March 2017 and are at the end of their estimated life span of four to five years. The notes are not commonly used for transactions, and stocks of banknotes of other denominations are "adequate to meet the currency requirements of the public," the central bank said.

Money market liquidity

The gradual withdrawal of the 2000-rupee banknotes and the higher-than-expected 874 billion rupee transfer by the central bank to the government as a special dividend, also announced May 19, may appear "disparate" events, but both are intricately linked with money market liquidity, QuantEco Research said in a May 20 note.

"Core liquidity would benefit and is now likely to be less of a concern in the coming months," QuantEco said in the note.

The rise in liquidity could range between 500 billion rupees and 900 billion rupees, Emkay Global estimated, assuming that 15% to 30% of the 3.62 trillion rupees that may end up in banks would stay as deposits. Emkay expects the notes to be initially deposited with banks, improving the system liquidity by as much as 1.4 trillion rupees to 1.6 trillion rupees.

"This durable liquidity addition through a new deposit base would ease off some liquidity pressure and, thus, may moderate (but not eliminate) the need for durable liquidity addition by the RBI" in the form of open market operations or cash reserve ratio cuts in the latter part of the fiscal year ending March 31, 2024, Emkay said.

The withdrawal of the banknotes could also lead to a near-term surge in high-value transactions such as the purchase of real estate and precious metals, QuantEco said.

No shocks

The sudden withdrawal of 500- and 1000-rupee notes in 2016 was disruptive for India's economy, with cash-reliant small businesses bearing the brunt of the bulk of currency suddenly losing legal tender status. Long queues were seen outside bank branches, with holders trying to exchange their old currency for new. The latest move by the Reserve Bank of India is likely to be less disruptive as the 2000-rupee notes remain legal until the end of September.

"There could be some adverse impact on small businesses, which hold these high denomination notes for managing their daily transactions, while there could also be some positive impact via households that may prefer to spend their existing stock of notes for discretionary transactions," Nomura said in its research note.

The net impact would likely be neutralized amid digital payment avenues and the likelihood that the central bank would accelerate the issuance of lower denomination banknotes, Nomura added.