Additional liquidity can be positive for near-term banking liquidity, favourable for rates: Axis MF

The hype around the overall demonetisation process should largely be discounted by the fact that the RBI has given an extended timeline for the entire process and the banks are better equipped to handle operations this time around in a more transparent manner without affecting business activities and inconveniencing customers, said Axis Mutual Fund in its Thinking Aloud Note on ‘Demonetisation 2.0’ that focuses on RBI’s decision to withdraw from the circulation of Rs 2,000 notes. “For the markets we believe, the additional liquidity can be positive for near term banking liquidity and overall in turn favourable for rates (more for short end) with negligible impact on growth.”

The RBI announced withdrawal of Rs 2,000 notes this week and have given time to deposit the notes with banks up to 30 September 2023. Also, a withdrawal of Rs 20,000 per person per day of notes in exchange is allowed. The announcement would be compared with 2016 demonetization announcement by the Government of India.

This is how the note withdrawal will play out, according to Axis Mutual Fund:

Some facts: Currency in circulation base has more than doubled in the last 6.5 years from around Rs 16 trillion to Rs around 33 lakh crore. Rs 2,000 denomination notes form around 10% of total currency in circulation as against Rs 500 and Rs. 1,000 denomination notes in 2016 which were more than 90% of O/s currency in circulation in 2016. The RBI is just stopping the circulation of Rs 2,000 notes and would consider it a legal tender. Also, the time limit for deposit is significantly higher at four months, compared to 45 days during the demonetization announcement done in 2016.

Macro variables: Generally, withdrawal of currency from economy can have impact on: Liquidity in banking system, Durable liquidity infusion, Growth and business activity

Liquidity: Axis MF said ‘We believe that banking liquidity due to currency deposits of Rs 3 lakh crore by September will increase and we also expect withdrawal of liquidity will be phased out over the next 3-4 quarters. Both banking and durable liquidity can see a near term increase by Rs 1.5-2 lakh crore.

Growth and business activity: As Rs 2,000 denomination notes is around 10% of total currency in circulation and with growth in UPI transactions over years, impact on growth on business activities would be negligible.Impact on markets: Deposits with banks would increase in near term to a tune of around Rs 1.5 -2 lakh Cr (net of exchange) which will lead to fall in certificates of deposits (CD) issuances and deposits rates of banks. Rates for short end of curve up to 3 years can fall by 20-30 bps as along with this liquidity surplus we are also near to peak of interest rate cycle and can expect cuts in the last quarter of this FY.

Secondly as banks need to maintain around 20-25% of deposits in government bonds as part of SLR requirements we can expect additional demand from banks especially in 3-5-year government bonds

Rates for 3-5-year G-Sec and corporate bonds can also see a rally to tune of 20-30 bps over next 3-6 months. Durable liquidity (core liquidity) can see an increase of around Rs 1 trillion which can lead to delay in OMO purchases by RBI impact could be that the bond curve can steepened post initial rally (short bonds to rally more than long bonds and spread between 3-year X 10 year which is flat currently can widen)