Opinion

Why we are in the midst of a liquidity crisis

Bhawarlal Chandak | Updated on September 17, 2019 Published on September 17, 2019

Blame demonetisation, a flawed GST and the damage caused by unscrupulous Chinese imports

The financial system and the economy are systemically more vulnerable now than ever before. The saving-investment growth nexus, the manufacturing base and its growth, the level and quality of employment, business operations, farm prices and income, the vigour and health of the financial system, liquidity, and the payment system are in a state of flux/reversion. Business uncertainty, solvency and liquidity worries are growing. Market funding and liquidity funding crises are resulting in an unprecedented liquidity gridlock in trade and industry. This liquidity crisis, along with deep structural weaknesses in the ecosystem, has further triggered an unprecedented economic conundrum. The risk of systemic events has increased.

Economic effects

Spill-over effects of demonetisation followed by GST have resulted in an unintended consequence of acute liquidity crisis due to a sudden interruption in the use of informal business funds — especially in the form of trade credit (TC). The crucial fact is that a high proportion of credit, savings, and investment in the economy are informally managed. Transaction demand for money can be met by TC, demand deposits and currency. A substantial part of TC flows/dealings is informal. In the pre-GST period, both informal and formal business funds/credit were flexibly used in business transactions. However, GST transactions require formal funds. A sudden contraction in deployment of informal funds/credit under the GST disrupted the credit chain and repayment cycle, resulting in inordinate lengthening of the average repayment period and credit defaults across businesses.

We need to understand the nature of informal business funds. These funds should not be treated and equated with funds generated through illegal means. The rationale and necessity of formalisation of huge unaccounted business funds at a nominal penalty and a framework for implementing the same are discussed in my article (BusinessLine, February 10, 2019). This can help in overcoming the liquidity crisis efficiently, effectively and speedily, while simultaneously generating extra revenue.

World over, TC or B2B credit sales are by far the single largest common source of working capital (WC) for businesses. In terms of credit intermediation and supply-chain financing, TC is far bigger than WC from banks. TC flows create liquidity by way of micro-circulation of credit; reintermediation of bank credit, suppliers’ credit and private savings; providing last-mile links in credit creation and distribution chain; and as lender-of-last-resort for non-bank- as well as many bank-financed units. Systemic disruption/contraction of informal TC flows following demonetisation and GST triggered the liquidity crisis.

Millions of day-to-day inter-firm trade credit-based transactions and repayment flows have been impacted. Decline in TC velocity worsens liquidity conditions. The World Bank warns that under financial distress conditions, the TC network can reverse its role from credit multiplier to liquidity shock amplifier. Perceived creditworthiness, credit discipline and confidence is in general decline. Counter-party payment risk spirals, customers delay payments to vendors and all players are reluctant to release payments.

Under these ‘illiquidity’ conditions, many firms attempt to conserve liquidity and increase their precautionary cash balances, which sets off a spiral in falling payment volume. The payment system plays a key role in the transmission of liquidity shock. Once a critical threshold of trade debtors’ defaults/delays is reached, there is possibility of a sudden illiquidity cascade through the entire system. These are the central features of the present liquidity crisis. There is a clear relationship between late payment/defaults and the rate of insolvency and output loss.

Structural problems

The RBI’s assertion about surplus liquidity in the banking system means little when the economy is reeling under the liquidity crisis. Low credit confidence and the inter-se non-convergent working of banks and businesses aggravate the liquidity crisis. Further, filling the huge credit financing gaps left by immobilisation of informal business funds/credit is beyond banks’ resources, operational framework and reach. Bank working capital and TC form interdependent and inter-locked functional links along the financing network. Easy monetary policy and boosting banks’ resources to encourage bank credit flows will be of limited help without strengthening of the TC channel, as bank credit ultimately travels through the TC chain.

Structural infirmities on multiple fronts is compounded by massive unscrupulous Chinese imports since the mid-2000s. It has systemically damaged the structural configuration of the economy in terms of consumption, manufacturing, savings, investment, employment, money supply, black money and trade competitiveness.

Steady increase in under-invoiced/mis-declared/smuggled goods on a massive scale from China have caused deep and enduring structural damage to the manufacturing base. Capex, technological and skill development, employment, trade competitiveness and tax revenue have been impacted. Chinese imports (excluding value of under-invoiced/smuggled imports) in dollar terms surged with a CAGR of 25 per cent during FY2003-2018. Consumption goods dominate imports. Imports of final products/CKD/critical components keep manufacturing value chain and capex at a low level. No large economy can achieve a high and steady state of growth with such an import-intensive consumption and production structure. Aggressive Chinese export policies and under-invoicing create formidable entry barriers for the indigenous industry.

Information failure in terms of quantity, quality, prices of unscrupulous imports creates cost-price uncertainty and risk of unknown/unequal competition for firms. These discourage production/capex. Many manufacturing units have switched over to trading in Chinese products. Besides these direct economic costs, is the high invisible cost of information failure in terms of capex not undertaken and goods not produced, as businesses anticipate in advance that they cannot compete with Chinese imports.

The import-intensive consumption and production structure dampens the GDP-saving-investment growth multiplier. This is reflected in deceleration in savings (35 per cent in FY12 to 30 per cent in FY18) and investment rates (39 per cent in FY12 to 30 per cent in FY18).

The high currency growth is not generating higher growth/inflation, as it is mostly being used by general public at large to finance under-invoiced imported consumption goods and industry inputs. So, the use and generation of cash/black money is generalised. The RBI’s unawareness of these facts resulted in critical shortcomings in the demonetisation strategy and the objective of evolving into a less-cash economy.

A way forward

Structural damages on multiple fronts arising from the spill-over effects of massive unscrupulous Chinese imports need to be understood. Concerted measures are needed to curb shady import practices. The Make in India strategy needs to be synchronised with planned phasing out of illegal/under-invoiced imports along with spurring of domestic capex and capacity. Besides formalisation of informal business funds, identification of breaks in TC flow chains and devising TC interventions can vitalise the supply-chain financing network without loss of time. Liquidity is necessary in meeting the challenges from structural weaknesses and the slowdown.

The writer is former DGM, SIDBI

Published on September 17, 2019
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