India’s ‘demon’ plan yields unintended consequences

“Reports that say something hasn’t happened are always interesting to me because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones”

That was Mr. Rumsfeld in 2002 at the Department Of Defense news conference. He could not have been more precise in picking his words to convey precisely nothing. Some people have this great ability to use words like a potter uses wet clay. They say or act in a particular way, yet miraculously, when things don’t pan out as they had intended or expected, their earlier utterances are now interpreted to make perfect sense of the current circumstances.

We were in India recently, trying to assess the impact of the demonetisation (‘demon’) exercise on businesses and the readiness of participants for implementation of the impending goods and services tax (GST) regime. Indian Prime Minister Modi’s stated reasons for demon – to crack down on corruption – will in hindsight be forgotten. The narrative has settled on the march towards a cash-less society. What is evident is that it was a master political gambit. For the first time, the BJP is now regarded as the party of the poor, a perception that makes for strong political foundations. Despite the disproportionate hardships imposed on the poorer sections of society during demon, the oft heard remark was “we suffered but Mr Modi is making the rich suffer even more”.  

Calm after the demon storm

Life and commerce are returning to normalcy. As currency notes get back into circulation, cash as a medium of exchange is returning to its primacy. In India, old habits, illiteracy and the low level of awareness of technology are still barriers to overcome. The adverse effects on business were felt most by those who have a rural bias to customer demand and use wholesalers as intermediaries to reach customers. High-value goods sold on credit (except property) did not suffer much. The rationale for demon, which was accompanied by assurances from the Government to an extent that the people including myself believed, was that those with ‘unaccounted wealth’ would be scared to disclose their cash holdings. Only those who had nothing to hide would deposit their cash back into the system to exchange for new notes. With old notes invalid, it was the most equitable way of punishing the crooked. Surely this would lead to contraction of demand, as people with cash who did not exchange it would face a loss of wealth, but the nation would benefit.

As is often the case, the unintended consequences won the day. By various ingenious means, all the cash in circulation, both the legitimate and the unaccounted, made its way back into the system. There are lingering worries of a witch-hunt through big data analysis for those who have misused the system. That is a real risk, but so far incidents have been few and far between; none of the corrupt have suffered to date. The net result was a spike in deposit growth for the banking system at a time of anaemic credit demand in the economy.

All banks benefited from this abundance in deposits. A liquidity surge led to falling bond yields. Even finance companies, who can’t accept savings and current deposits by law, were beneficiaries from the falling interest on their liability side. Property and gold (the traditional stores of value and repositories of unaccounted wealth) were disrupted, hence excess liquidly has flowed to the stock markets.

In our portfolio, the overall exposure to India remains quite stable if you compare current weightings to that of October 2016. I did trim some core holdings at the margin to appropriately position the portfolio and I sold out of only one cyclical, replacing it with another: mining group Vedanta.

We have always focused on owning sustainable growth businesses – those able to manage through downturns and crises. Demon was an unexpected and hitherto unexperienced challenge. All our core holdings have navigated this challenge well, though a couple were more affected due to their greater reliance on rural demand. With GST implementation around the corner now, it is quite likely that we will encounter problems in the next three to six months. But there is little doubt that the organised sectors are much better prepared and better positioned to gain share at the expense of those that are disorganised. The challenge for us in India is valuations. As we have mentioned before to clients, India is home to several excellent businesses, but we struggle to pay what the market currently expects. These elevated valuations are a result of benign liquidity and a lack of alternative outlets for savings, not rapid growth in earnings or improved cash flows.