The withdrawal of the Rs 500 and Rs 1,000 denomination bank notes may provide a strong impetus to greater use of the formal financial system - the banking system - for the intermediation of commercial transactions, especially in the retail segment, according to Moody’s Investors Service.

The global credit rating agency observed that the government move has meant that a large proportion of the population will have to access banking channels at least once, so as to convert their existing holdings into the new legal tender. The demonetised notes account for around 86 per cent of the existing currency in circulation and around 9.5 per cent of GDP.

For first-time users, studies have shown that they tend to keep using the banking system once they initiate the process. Therefore, Moody’s expects a material proportion of the first-time/very infrequent users to become more sticky customers of the banks. This development should also benefit the banking system in the form of a higher level of low-cost deposits, although this benefit may not be apparent on a near-term basis.

Cash deposits

In addition, retail payments systems, which remain dominated by the banks, will be a clear beneficiary of the demonetisation move as people may see these channels as being much more convenient compared to the hassle they may experience in transitioning to the new denomination notes.

The agency assessed that currently, the banks are experiencing significant inflows into their deposit base as customers deposit their existing holdings of the demonetised notes, a trend that will continue for the next 3-4 weeks. “But, as cash availability increases and the current restrictions on cash withdrawals are lifted, sharp declines in the deposit base will occur in the near future.

“Once this volatily subsides and stability is achieved, possibly around three months from now, we estimate that bank deposits will increase by around 1-2 per cent compared to what they would have been without the demonetization scheme,” said Moody’s.

The agency’s expectation of a relatively low level of increase in deposits is based on the assumption that the role of cash – as a medium of transaction – will not change materially in the near term in India's economy.

However, as the cash intensity of the economy reduces over the medium term, driven by a combination of the informal economy coming into the ambit of the formal one and a higher proportion of cashless payments, bank deposit levels may benefit in a more meaningful fashion, it added.

LAP and MFIs: asset quality to deteriorate

Apart from the impact on funding conditions, Moody’s expects asset quality to deteriorate in the loans against property (LAP) segment. A significant part of the LAP client base would have an informal economy component and may be impacted by demonetization. The impact would be even more if lenders turn cautious on this segment as easy refinancing has played a key part in putting a lid on non-peforming loans (NPLs) in this segment.

The micro-finance segments would be impacted significantly during the transition from the old notes to the new ones as transactions in this segment are predominantly cash based. However, once the transition is completed, asset quality may stabilise.

Moody’s assessed that the broader asset quality of the banking system would be impacted if economic conditions remain affected beyond the transition period. Both corporate and SME customers remain fragile, and are not in a position to absorb a sustained period of economic weakness.

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