In a surprise late evening announcement on 8 November, Prime Minister Narendra Modi told the nation in a TV address, that come midnight, Rs 500 and Rs 1,000 notes will no longer be legal tender.
One reason for doing this is to tackle the menace of fake notes. The second reason for doing this is to tackle black money.
As I mentioned in the earlier column, the move seems to be inspired from the American dollar as well as the British pound. In the United States, the highest denomination bank note is $100. When it comes to the United Kingdom, the highest denomination bank note issued by the Bank of England is £50. In the United States as well as the United Kingdom, the highest denomination note is essentially 50 times the smallest denomination note of one dollar or one pound.
In India, up until now the highest denomination note was Rs 1,000 and this was 1,000 times the smallest denomination note of Re 1, issued by the ministry of finance. When a currency has notes of higher denomination, it is easier to launder money i.e. store black money, as it takes less space and weighs less as well.
As Ritika Mankar Mukherjee and Sumit Shekhar of Ambit Capital wrote in a recent research note: “For instance, the weight of Rs 1 crore in the form of hard cash rises from 12kgs to 100kgs if the denomination of the sum is changed from 1,000-Rupee notes to 100-Rupee notes.”
Also, Rs 500 and Rs 1,000 form the bulk of the total amount currency notes in the Indian financial system. As per the Reserve Bank of India, the total amount of paper notes in circulation in 2015-2016 amounted to Rs 16.4 lakh crore. Of this, the high denomination notes of Rs 500 and Rs 1,000 amounted to Rs 14.2 lakh crore or a little over 86 per cent. The Rs 500 notes amounted to Rs 7.9 lakh crore whereas Rs 1,000 notes amounted to Rs 6.3 lakh crore.
This basically means that anyone who has black money stored in the form of currency notes is more than likely to have it in the form of Rs 500 and Rs 1,000 notes. Black money is basically money which has been earned and on which taxes have not been paid. As Mukherjee and Shekhar write: “Given that 48% and 39% of the total value of currency in India is in the form of Rs 500 and Rs 1000 notes respectively, discontinuing usage of either of these notes can increase the physical costs and risks of holding black money significantly.”
Given this, anyone who has these notes, must go deposit this money in a bank account or in a post office account. And if the money being deposited is black money then questions are likely to be asked by the income tax department. Hence, that is unlikely to happen, at least not in a direct way.
One repercussion of this move that is being widely talked about is that it will lead to a fall in the real estate prices. Typically, real estate throughout the length and breadth of India is bought using black money. A significant part of the payment is made in cash. Either this is black money being used or it is white money being converted into black. Experts are of the view that the Modi government’s crackdown on black money is likely to lead to real estate prices coming down significantly.
The logic is that with Rs 500 and Rs 1,000 no longer being legal tender, it will become difficult to make the black component of the payment using currency notes. With the cash component becoming difficult to pay, it is expected that the real estate companies and builders will have to cut prices.
Further, the government plans to launch new Rs 500 and Rs 2,000 notes. It will not be so straightforward to exchange the old Rs 500 and Rs 1,000 notes with these new notes, at least that is the feeling that currently prevails.
This is the logic being offered by experts who are forecasting a fall in real estate prices. As Yashwant Dalal, president of the Estate Agents Association of India told The Economic Times: “Property markets will see around 30% correction in prices…Apart from big property markets, tier II and III cities will be worst affected.” Property prices in tier II and tier III cities will fall more because the black component while buying a home is higher in these cities.
Further, as Anuj Puri, chairman and country head, JLL India, told Mint: “We have just witnessed a tremendous step towards increased transparency in the Indian real estate industry…The effects will be far-reaching and immediate, and shake up the sector in no uncertain way.” Rajiv Talwar, CEO of DLF, was a little more direct than Puri when he told The Economic Times: “There is bound to be a downward pressure on prices of everything including real estate.”
How do I see the situation? Given that I have been bearish on real estate for as long as I have been, it would be easy for me to say that prices will crash. But the past data (whatever limited data we have on real estate) doesn’t suggest the same.
So, my feeling is that real estate prices will fall, but whether they will crash or not, depends on how the government reacts to the situation. Allow me to explain.
The current financial crisis that the world is dealing with, essentially started once the investment bank Lehman Brothers declared bankruptcy in mid-September 2008. Real estate prices fell across large parts of the world. But India beat the trend.
The question is why did this happen. Why did real estate prices in India not crash? How did India manage to beat a global trend? The answer lies in Figure 1.