What will be the effect of banning 500 and 1000 notes on stock markets in India?

The ban on INR 500 and INR 1000 notes, announced by the Indian government on November 8, 2016, had significant and multifaceted effects on the Indian stock markets. Here are some key points:

Immediate Impact

• The announcement led to a sharp decline in the stock market indices. The Bombay Stock Exchange's benchmark index, the BSE Sensex, plummeted by roughly 1,700 points or 6.4% in just four trading days, while the National Stock Exchange's benchmark index, the NSE Nifty, fell by approximately 550 points or 6.3%15.

Market Volatility and Uncertainty

• The initial drop was largely due to the uncertainty and ambiguity induced by the demonetization announcement. Investors were concerned about the potential impact on corporate profits and the overall economy15.

Sectoral Impact

• Different sectors reacted differently to the demonetization. While sectors closely linked to the unorganized economy, such as small and mid-cap enterprises, suffered significantly due to liquidity crises, sectors related to digital payments, fintech, and e-commerce saw a surge in their stock prices. Companies like Paytm, HDFC Bank, and ICICI Bank benefited from the increased demand for digital commerce and online banking services15.

Long-term Recovery

• Over the next several weeks, the stock market steadily rebounded as the government implemented measures to mitigate the fiscal impact of demonetization. The Reserve Bank of India (RBI) injected more liquidity into the banking system, and as the market stabilized, inflows into mutual funds, especially small and mid-cap funds, began to rebound. These funds eventually outperformed the overall market in the years following demonetization1.

Impact on Mutual Funds

• There was an initial rise in mutual fund inflows as investors sought alternative investment options after the cash ban. However, the long-term impact was more complex, with some funds outperforming others. The liquidity crisis affected small and mid-cap funds initially, but they later rebounded due to improved economic factors and lower interest rates making equities more attractive1.

In summary, the ban on INR 500 and INR 1000 notes led to immediate market volatility and a sharp decline in stock indices, but the market recovered over time as the government's measures took effect and digital transactions increased. The long-term impact varied by sector, with some sectors benefiting significantly from the shift towards a cashless economy.