MSMEs tripped by trade credit collapse

Adequate and timely credit flow continues to be the corner-stone of the MSME policy framework since Independence. To facilitate the same, various expert committees on the subject have made recommendations from time to time.

Financial and institutional networks have been developed to support the sector. However, the cost-benefit analyses of huge cumulative credit flows, subsidies, tax revenues foregone, NPA write-offs and various development expenditures point to inefficient use of resources. MSMEs still lack resilience and innate strength. The Covid crisis has amplified these fragilities to the point of breakdown.

At the root lies a sociological malaise — the breakdown of trust and credit morality, and with it, the freezing up of informal credit. Bank credit cannot plug this gap because it works in tandem with trade credit, and cannot substitute it.

TC and business

National and global data show that bank credit plays a very limited role in the financing of MSMEs.

The International Finance Corporation’s Financing India’s MSMEs Report, 2018 estimates the total MSME credit gap at 70 per cent (demand minus formal credit) of which 70 per cent is working capital (WC). The Association of Chartered Certified Accountants, London, finds that SMEs globally receive more trade credit (TC) than WC from banks. The credit-gap concept is naïve as it remains unbridgeable by banks. It does not take the unique role of TCs — as a predominant and ubiquitous source of WC for MSMEs in India — into account.

The rise and success of business communities like Marwaris in trade and industry is basically founded on TC. TCs are crucial for both small business and corporates. The banking network does not have the bandwidth and institutional milieu to replace the role of TC in small businesses. Surprisingly, we continue to believe in the banks’ ability in filling the credit gap.

TC forms the prime operational base of MSMEs’ WC structure. TC intermediation runs through raw material suppliers to producers, wholesalers and retailers. Its repayment chain runs in the reverse order. Credit velocity and volume, credit creation and distribution at the enterprise level greatly depend on the length and breadth of the circulatory TC stream and the speed of its repayment cycle.

TC is linked to every aspect of a business: production, sales, WC management, investment. Its advantages include:

It allows for high leveraging, informality, collateral-free, quick response, flexibility, and better understanding of credit needs, and provides a supportive role during distress. Its working is compatible with the needs of businesses.

In the initial stages of a firm, TC helps in increasing its market visibility in terms of its turnover, profitability and product quality. This works as a signal to banks to finance such firms.

Large firms with easy access to bank credit, suppliers’ credit and own funds can channelise funds through TC to credit-constrained MSMEs. The World Bank advocates this. This does not, however, happen in India.

Bank WC and TC form interdependent links. The bank-credit multiplier depends much on the depth and length of its sequential flows through the TC chain. Interconnectedness between TC and bank networks implies that liquidity and default shocks in TC network can trigger chain reactions in the banking sector. The World Bank warns central banks against this systemic risk in the event of financial instability.

Dysfunctional TC

TC is based on trust. The deterioration in payment culture and moral values, rising opportunism and vanishing socio-business stigma attached to credit repayment delays and defaults have weakened this trust. Following the lockdown, inter-firm financial and economic interactions faced further disruption. These worsened already weakened TCs’ informal systems by wrecking business conventions and discipline. Uncertainty around cash flows, receipts and payments increased.

Erosion in trust and confidence in the counterparty’s willingness and ability to pay back triggers a TC collapse. More cash-based and fewer credit-based transactions follow. These severely curtail business activities. Higher precautionary holding of liquidity and play-safe mode behaviour reflect spurt in currency demand. Unless trust is rebuilt, these adverse consequences will continue unabated.

The TC repayment cycle remains broken despite relaxation of business operations. Trade debtors’ willingness to pay has nosedived. Buyer-supplier credit ties are threatened by the fear of opportunistic behaviour. Survival instinct and uncertainty force businesses to consolidate their own financial position. Many customers are not making payments to vendors, while players move to safe-mode and are reluctant to release cash. Non-payment of trade debts cascades into payment system contagion. B2B deals are now increasingly done on cash-and-carry basis. Firms are abandoning their responsibility in honouring the rules of TC ecosystem. The invisible cost of these actions is very high in terms of business deals not effected, goods not produced, capex not undertaken, firms not started as businesses anticipate in advance that they cannot fully rely on counterparties’ commitment.

Correcting course

The near-automatic Emergency Credit Line Guarantee Scheme for ₹3 lakh crore is a very good credit boosting plan for MSMEs and small firms. Given the fact that banks cover only about 10 per cent of MSMEs, for most of the remaining 90 per cent of unbanked firms, TC remains the-lender-of-the-last-resort. Second, higher liquidity hold-back and worsening repayments impact the credit multiplier. And when the credit multiplier falls, it only becomes harder to sustain growth.

Pump-priming the economy through higher bank credit to MSMEs, public expenditure and monetary easing may be shortlived in its effectiveness, as a sizeable part of finance travels through the dysfunctional TC network. We need greater understanding of working of TC network, how Covid-19 has led to a trust and confidence crisis, and the role of industry associations (IAs) in overcoming this. Trade bodies/IAs can play key role in restoring trust in the TC ecosystem. They need to assume a leadership role in pushing self-regulation/self-discipline for business survival.

Collective action against wilful defaulters and business malfeasance should become a norm. IAs can be quite effective in dispute settlements, TC recovery in terms of cost and time, compared to legal remedies. Their knowledge of working of business deals, reputational weight and moral authority can work effectively. Coordination failure among the firms, IAs and lack of collective action against TC renegades encourage indiscipline in inter-firm dealings.

The government needs to address this coordination problem and direct IAs and TC players to be disciplined in B2B credit dealings. The TC ecosystem improvement measures can greatly solve the perennial credit-constraint issue of MSMEs and the Covid-19 led business crisis. The progress of Atamnirbhar Bharat depends on this revival.

The writer is former DGM, SIDBI

COMMENT NOW