A rescue plan for liquidity-hit MSMEs

The epochal GST was expected to boost manufacturing, capex, employment, tax revenue and formalisation of the informal sector. However, these objectives remain mostly unrealised due to disruptions in circulation of unaccounted/informal business capital/working funds following demonetisation and GST.

History shows that major macroeconomic disturbances are associated with disruptions in financial flows. Slowdown caused by such disruptions are painful and long drawn out. Widespread inter-firm payment delays/defaults and low bank credit confidence transmit liquidity shocks across businesses.

Firms and farms are experiencing a liquidity gridlock-led recessionary trend despite the volume of currency in circulation, bank credit and deposits being higher than their pre-demonetisation levels.

Narrow liquidity view

The general understanding of liquidity is bank-centric. However, over 94 lakh business units’ income tax return data for FY 2014 show banks’ financing covered about one-third of their total turnover. Taking into account turnover of firms below the taxable slab and unaccounted transactions, more than two-thirds of business financing is through non-bank finance channels (NFCs).

Anecdotally, only 5-10 per cent of MSMEs avail themselves of bank credit. NFCs are lenders-of-last-resort for MSMEs/unorganised businesses.

Banks’ excess liquidity holding in SLR, large financial investment/liquidity holdback by financially sound firms, and flight to safety and security have created a liquidity mismatch in the financial system. This aggravates the liquidity crisis.

As such, bank-centric liquidity-enhancing measures alone will have very limited impact.

GST impact

The common explanation offered by businesses for the widespread slowdown is acute shortage of liquidity in terms of formal business capital to finance GST transactions. Available, unaccounted business capital cannot finance these.

This mismatch arising from disruption in circulation of unaccounted business capital/funds is creating unprecedented liquidity crisis across businesses. This capital carries the stigma of black money. Its use in formal transactions carries risk and fear of income tax scrutiny, harassment and retrospective tax.

Financing of numerous day-to-day formal business transactions has been hit. This aspect should have been considered while implementing GST. Unrealistic treatment of this capital on par with black money under voluntary income disclosure schemes disincentivised its conversion into formal money. Who will pay high penalty rates for the survival/livelihood capital, so essential to run a business?

Many small firms accumulate business capital over the years out of incomes which may fall below the tax-paying slab. Tax-evasion at the individual business level becomes a necessity due to prevailing industry practices and tax evasion by competitors.

But rather than earning higher unaccounted income, stiff competition generally forces the entrepreneur to pass on gains from tax evasion into lower prices. In general, MSMEs/small traders don’t earn a fair economic return on the present value of their investment.

Further, during demonetisation, a part of unaccounted business capital got deposited in bank accounts with relaxed KYC norms. Now, with withdrawal requiring full KYC compliance and subsequent monitoring, including a trail of its uses, by income tax authorities, there have been other consequences. A part of this business capital remains invested in bank deposits. This adds to reduction in funds’ availability for businesses.

A way out

The Prime Minister’s repeated call for formalisation of MSMEs, his support mission for the unorganised sector and assurance against non-scrutiny of their past business records can work only if the conversion of this unaccounted capital but earned from legitimate business activities is formalised with a low penalty.

It is an imperative for policymakers to appreciate that this money cannot be treated at par with black income generated through a dubious manner, or by indulging in anti-social/anti-national activities. Low penalty is thus justified. Most businesses prefer to do clean and hassle-free business under GST. Restoring full circularity of business funds increases velocity of money. This boosts liquidity, businesses’ confidence and activities.

Without this, businesses face a recession triggered by a liquidity crunch. However, survival instinct forces businesses to game the GST system. This has already started. It dents GST’s objectives of formalisation of transactions and higher tax revenue.

Draft proposal

* Conversion of business capital in the forms of unaccounted cash/bank deposits into formal funds may be allowed to GST-registered firms only with 10-20 per cent progressive penalty structure.

* Conversion may be restricted to deposits up to ₹2 crore. This may facilitate a business to have an annual turnover of ₹8-10 crore with four to five working capital cycles in a year. It may cover a majority of the firms.

* Nitty-gritties of the scheme, penalty rates and conversion amount can be fine-tuned/changed after discussions with trade and industry. This will enormously help businesses to increase their business under GST.

* Employment will increase. Tax revenue may surpass the estimates. It must be recalled that in the past this money was used in financing economic activities.

To bring informal businesses under GST, it would be practical to have such a scheme with the following indicative conditions:

* All the unaccounted funds/cash holdings/bank deposits of a business need to be deposited in a designated current account of a bank linked to business activities under GST;

* The deposit can be used for business transactions only;

* A graded penalty upfront on the total declared deposits/cash may be imposed; example, 10 per cent up to ₹50 lakh and 20 per cent for ₹50 lakh to ₹2 crore.

No doubt, some black money may flow in under the scheme. However, the saving grace is that this money will then be used for productive purposes. It may be considered a small evil to achieve larger national goals in terms of business growth, employment and formalisation of business transactions.

Advantages of the move

* The supply chain financing network can be boosted without loss of time.

* Transmission of liquidity and late payment shocks are controlled.

* Revival of the unorganised sector will be faster, steady and efficient.

* Increased funds flow helps in better farm prices. Earlier use of informal funds in purchasing of farm output by millions of traders/grain merchants during harvest time and selling these during lean season did help in holding the price-line.

* GST revenue will leapfrog with steady growth in turnover.

* Formalisation of business transactions will be easy, faster and widespread.

* Higher growth will mitigate NPA problems and lead to better NPA asset value.

* Drastic reduction in transaction velocity of money leads to widespread depression. This will be reversed.

The writer is a former deputy general manager, SIDBI

COMMENT NOW