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5 reasons why demonetization affects interest rates
On 8th November, the government made a shock announcement—500 and 1,000-rupee notes would be demonetized to curb black money, counterfeiting and fight terrorism.
The move resulted in about 85% of the total value of currency being taken off from circulation.
It is also likely to have short and long-term effects on the economy. One reason for this is the impact on interest rates.
Here are five reasons why demonetization affects interest rates.
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High deposits in the banking system
Banks have witnessed a gigantic increase in deposits. This is mainly because of the short deadline for depositing high-value currency notes. Around Rs 5.5 lakh crore has already been deposited in banks till November 18, as per government data. This resulted in high liquidity in banks. In comparison, currency worth Rs 1.03lac crores has been issued till November 18.
(source : https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=38643) Since it could take a few weeks or possibly even months before the new currency gets into active circulation, banks will be flush with cash.
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Deposit rates slashed
With an abundant increase in deposits, deposit rates get slashed. This shouldn’t come as a big surprise to customers—it’s simple demand-supply economics. As the supply (deposits) increase, prices (deposit rate) fall. And that’s what has happened. Most banks have announced a cut. ICICI Bank and HDFC Bank cut deposit rates by as much as 0.25%. This cut is likely to continue too. “All rates will fall,” said SBI Chairman, Arundhati Bhattacharya in a recent report, indicating that deposit rates, as well as lending rates, could decrease further.
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Attractive borrowing rates
Yes, the demonetization caused deposit rates to dip, but there is still some good news for customers. An excessive influx of deposits coupled with a poor demand for credit will force lending rates to decrease too. While this may not happen immediately, it can come in handy for prospective buyers looking for cheap loans in the near future.
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Disinflationary cash crunch
The demonetization has led to a cash crunch in the system. People have limited access to 100-rupee notes. Even those who did receive 2,000-rupee notes are unwilling to spend it because of issues with getting loose change. This means, demand for goods and services is likely to fall in the short-term. This is potentially disinflationary. After all, as demand falls, prices fall too. This could give the RBI room to cut key lending rates in the near future.
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Neutral effect in the long run
Lower demand because of the demonetization could exert a downward pressure on inflation in the near term. Similarly, categories such as food, housing and transport that have a higher cash component could witness a dip in prices. However, the government’s tax revenue is likely to increase. This could translate into higher investments and expenditure by the government. This could push up employment and incomes, and thus demand, in the long run. Hence, the impact on inflation—and thus interest rates—is expected to be neutral in the medium to long run, according to a CRISIL report.
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Rs 3 lakh crore
The Indian government scrapped 500 and 1000-rupee notes worth Rs 14 lakh crore, as per a Forbes report. Of this amount, roughly Rs 3 lakh crore is not likely to be exchanged for new notes, the Forbes report added. This amount is likely to be booked as profit by the RBI and transferred to the central government as dividend. Meaning, this could be additional income for the government.
