Opinion

RBI’s liquidity boosters are destined to fail

Bhawarlal Chandak | Updated on April 21, 2020

The informal trade credit channel, without which banks cannot access the last mile in business, has broken down. This needs to be fixed

Our financial system is more vulnerable now than ever before. Disruptive events such as the IL&FS, DHFL, PMC and YES Bank fiascos have a greater chance of breaking out after the lockdown. What’s worse is that measures taken by the RBI to transmit liquidity into the economy are destined to be ineffective, because they do not take into account the very nature of credit flows, of which bank credit forms but a small component.

The payment system (PS) is a key channel in the transmission of such vulnerabilities across the financial system. Inter-firm funds flow related to trade credit (TC) is a critical element in our PS. The coronavirus crisis will further worsen late payments/defaults conditions.

Dysfunctional trade credit

The role of the TC network (the largest source of working capital) in credit intermediation, micro-circulation of credit flow and the credit-based payment system has weakened in the recent years due to declining trust, deterioration in payment culture and vanishing social stigma attached to credit default/bankruptcy. In general, perceived creditworthiness and payment morality have declined.

With the advent of the GST, these legacy drawbacks are amplified by the sudden stop in circulation of the informal/unaccounted part of TC in financing B2B transactions. In the pre-GST period, a substantial part of TC funds flows in business transactions comprised informal/unaccounted business funds. Social attitudes and ethical mores can change dramatically during a crisis period. Fear of opportunistic behaviour, high counterparty risk and uncertainty in TC repayments/cash flows could lead to higher holding back of liquidity. In these conditions, the lockdown can lead to a serious gridlock in PS. It is repayment that completes the recycling of loanable funds and makes lending sustainable.

Spillover effects

The global financial crisis of 2008 was triggered by repayment defaults on subprime mortgages. Payment markets were the first to come under stress during the Lehman failure. Inter-firm long payment delays/defaults, growing uncertainty about cash flows, receipts and payments are the central feature of the present liquidity and growth crises. These adversely impact credit confidence, credit flows, credit practices, liquidity distribution and business activities. With the lockdown, the PS faces uncertainty and chaotic conditions. It is similar to a highway traffic jam. Once a jam takes place, everyone forgets/ignores road discipline and tries to move ahead. Chaos and commotion follow.

Adverse feedback loop effects of millions of day-to-day micro-level commercial deals can hurt velocity of liquidity circulation, financial stability and output. Creditors/investors move into play-safe mode, causing poor monetary policy transmission and drying of business liquidity. With the coronavirus crisis, the risk of financial system breakdown looms large.

RBI’s liquidity measures

Non-banking financial channels and businesses in general are facing a severe liquidity bind, despite a series of policy rate cuts and liquidity-boosting monetary policy transmission measures. Boosting refinancing facilities to NABARD, SIDBI and NHB and targeted long-term repo operations for NBFCs are going to be of limited help, as uncertainty and confidence contagion will impact credit velocity.

Lower velocity negates effects of an expansionary monetary policy. Further, it is crucial to note that bank credit covers just around 10 per cent of MSMEs. So 90 per cent remains outside this package. A similar package in the 2008 crisis had very little impact on the financials of MSMEs. Bank liquidity measures over the last one year or so ended in massive liquidity surpluses (now at ₹12 trillion) with the banking system, whereas businesses are increasingly facing a liquidity crisis. This is because the TC channel as the operating base of working capital has become unstable.

The TC network provides last-mile links in credit creation/distribution chain. A fragile TC network is akin to clogged last-mile field-level canals in an irrigation system. Total output and productivity suffer even when ‘water’ (read credit) supply at macro-level is sufficient. It is the micro-circulation of TC which facilitates liquidity flows to firms of all sizes and thereby imparts vitality and growth to economic activities. Circulatory and multiplier effect of a bank’s working capital depends on the depth and length of its sequential and easy flows through the TC chain.

Liquidity mismatch arising from non-convergence between demand and supply of bank credit, low credit confidence, excessive SLR/reverse repo investment and an intractable NPA problem are drags on the economy. As such, bank-centric monetary measures have serious limitations in overcoming liquidity/credit gridlock.

Failed TreDS initiative

A prompt payment mechanism for MSMEs through TReDS exchanges, sector-specific funds and frequent capitalisation of banks are less effective. A large number of PSUs are registered with the TReDS exchanges. In 2018, the government made registration mandatory for companies with turnover exceeding ₹500 crore. As on February 2020, only 8,211 MSME sellers and 1,530 buyers were participating on the TReDS platform.

The value of bills discounted was merely ₹5,500 crore in FY 2018-19 against the estimated MSME annual sales of about ₹14 lakh crore. Market reports indicate that the 45 days’ payment period of MSMEs’ dues is circumvented by non-acceptance of goods in time, asking suppliers for revising bill dates/relodging/delayed raising of bills. Complaints are not made out of fear of losing business. PSUs, government departments, and large corporates themselves are facing a liquidity crunch. So, TReDS is of very limited use to MSMEs.

The way forward

The lockdown can worsen the economic and financial contagion via linkages among credit, liquidity, confidence and payment channels. Prevention of the contagion is an urgent necessity. Identification of breaks in the cash/TC flows and devising trade finance interventions to mitigate the micro-liquidity problem, facilitating availability of TC along the supply chain to absorb liquidity shocks and preventing closure of financially squeezed/credit constrained but solvent and efficient firms are required. Accelerated payments of trade dues by PSUs, government departments and corporates is necessary.

The formalisation of informal/unaccounted business capital at nominal penalty rates for GST-registered firms (see ‘Rescue Plan for Liquidity-hit MSMEs’, BusinessLine February 10, 2019) can easily boost liquidity across firms while generating an additional revenue stream. Greater understanding of the TC network, manifestation of its behaviour under financial crisis and uncertainty, working of trust and confidence channels and linkages between bank and TC networks are required to have better perspective of ground reality.

Industry associations (IAs) need to play crucial role in maintaining credit-discipline, self-regulation and engender transactional trust/integrity in the TC ecosystem. They should take collective action against wilful defaulters/opportunistic behaviour in private credit. IAs’ reputational weight and moral authority can work more effectively in solving the problems of late payments/bad debts/trade disputes in private credit. Coordination failure among the firms, IAs and their members result in growing indiscipline in TC dealings. The government needs to coordinate and direct IAs and TC players to bring institutional discipline in B2B credit dealings.

The writer is former DGM, SIDBI

Published on April 21, 2020

Follow us on Telegram, Facebook, Twitter, Instagram, YouTube and Linkedin. You can also download our Android App or IOS App.

This article is closed for comments.
Please Email the Editor

You May Also Like