28 November to 5 December: Politically Incorrect

After a long period in which monetary policy has led markets, the baton has (at least in part) passed back to politicians over the last few months. After the surprise Trump election, yesterday saw the constitutional reform vote in Italy fail. Although expected, the margin of victory and strong turnout underscored a resounding loss for Prime Minister Renzi.

Moving 6,500km east, last week saw the first data release since India’s “demonetisation” (see details below). It is still too early to judge the impact of this measure and opinion is firmly split. On the one side, a number of economists have taken a negative view. They highlight:

  • Short-term disruption of removing 86% of paper currency in an economy where 98% of transactions by volume and 68% of transactions by value are in cash.
  • Potential ineffective and temporary effect on the black economy of removing relatively low denomination notes (values are roughly USD 7.5 and USD 15 respectively).
  • Risk that increased tax revenues are spent inefficiently.
  • Monetary tightening as a consequence of a “negative helicopter drop” whereby any notes not deposited with the RBI are cancelled.
  • Threat to credibility of government and the currency of such a blunt and sizeable move.

Certainly, we agree demonetisation stands out as bold reform, carrying not insignificant risk. However, we believe much of the criticism fails to take account of the broader context – demonetisation is not occurring in a vacuum:

  • Banking penetration has historically been low, but over the last 2 years the government opened 220 million accounts and made some benefits available only through this channel. Although most of these accounts remained otherwise dormant, over the past 3 weeks many have been activated. Therefore, the implementation of demonetisation as a “big bang” has meant that much of the informal sector has had no choice but to go digital. In this way, the process will create permanent change to business practices.
  • The starting point is extreme; according to the country’s first release of income tax data for 16 years, only 2.5% of Indian’s filed a tax return and only 1% ultimately made a tax payment. Given such a low tax take, and the evidence of a government focused on transparency and reform, we would argue the multipliers from government spending are likely to be positive.
  • Inflation is falling and will fall further, allowing the RBI to cut rates (starting this week). Moreover, it is not clear there will be a large reduction in the money supply. In theory, any notes not deposited with the central bank will ultimately be cancelled, thus reducing the cash in circulation. However, according to Credit Suisse, 56% of notes had been deposited 10 days ago, and some 75% may be exchanged over time. Thus, any reduction will be small. In addition, rather than cancelling the liability, the bank may choose to rebate the gain to the government to be spent on fiscal measures.

And this last point hints towards the principal risk. Such large-scale reform and management of currency walks a tightrope of positive change against faith in government. Just as we have spoken about in the past with respect to “helicopter money”, credibility is all important. If there is any sign of government acting nefariously or in self-interest, the process will unravel.

In conclusion, whilst the India story carries risk, we remain extremely positive. History teaches us that to unlock the underlying growth drivers of demographics, urbanisation and structural transformation, requires inclusive and quality institutions and government. The potential for such a combination in India is, in our view, unparalleled.

Last week, OPEC agreed its first price cut in 8 years (amounting to around 1% of global production and prompting a 16%+ rally in the oil price). We remain somewhat sceptical as almost all major oil producers are playing weak hands – they require any and all revenue and are therefore unlikely to stick to production targets. Former Saudi oil minister Ali Al-Naimi summarised it aptly on Friday commenting “Unfortunately, we tend to cheat”.

This week, the RBI in India meets on Wednesday, followed by the ECB on Thursday.

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