Trade Credit: The Hardy, Buoyant and Loyal Back-up -Part 2
BL Chandak 30 October 2020
The suppleness of trade credit comes from the elasticity of the micro, medium and small enterprises (MSMEs) sector itself, with its multi-nodal interconnectedness and the trust factor playing a crucial role to keep the machinery well oiled. An erosion of this factor could, however, be casualty of the pandemic, to deal a fatal blow to the sector. It is here that industry associations and business chambers would have a crucial role to play. 
Bank Credit and Trade Credit
Bank by working capital (WC) and short-term credit (TC) form interdependent links along the supply chain financing network. TC is pervasively networked with banking system in terms of credit demand, reintermediation, allocation, risk and repayment. Credit multiplier depends on the depth and length of its sequential flows through the TC chain. 
A firm’s bank WC need is greatly determined by the volume and tenure of its receivables and payables.
Interconnectedness between TC and bank credit means that liquidity, payment delays and default shocks in the TC network can trigger chain reactions in the banking sector and vice-versa.
In the initial stages of a firm, TC helps in increasing its market visibility in terms of its turnover, profitability and reputation which, given the informational opacity of small and young firms, work as a quality signal to banks to finance such firms.
Financing of collateralised receivables can be a good business for banks provided timely realization of their value is more or less certain. 
Large firms with easy access to bank credit, suppliers’ credit and own funds can channelise funds through TC channels to credit constrained MSMEs. The World Bank advocates this. However, the position is reverse in India. 
TC and Business 
TC forms an integral and prime operational base of MSMEs’ WC structure. TC intermediation chain runs through raw material suppliers to producers to wholesalers to retailers. TC repayment chain runs in reverse order. The velocity and volume of liquidity circulation greatly depend on the length and breadth of the circulatory stream flow of TC and the speed of its repayment cycle.   
TC is interlinked to every aspect of a business --production, sales, their growth, financial and liquidity management, investment. 
It is both a source (account payables) and use (account receivables) of funds. 
TC advantages include: High leveraging, informality, collateral free, quick response, flexibility, better understanding of business needs, and supportive role during slowdown, temporary distress or liquidity crisis. It is compatible to the needs of businesses. 
Dysfunctional TC 
TC is based on trust. Deterioration in payment culture and morality, rising opportunism and vanishing socio-business stigma attached to credit delays, defaults or bankruptcy have weakened the trust environment. Following the lockdown, inter-firm financial and economic interactions faced sudden disruptions. Uncertainty about cash flows, receipts and payments amplified.
The TC network is severely impacted by loss of faith and confidence in the counterparty’s willingness and ability to pay back. It messed up the already weakened TC’s informal institutional infrastructure and environment (business conventions, practices, rules, discipline, moral base, reliability of word of mouth, and code of conduct), undermining transactional trust and confidence in the TC network. Without trust, TC financing declines. 
Buyer-supplier credit relation is threatened by fear of opportunistic behaviour. More cash-based and fewer credit-based transactions follow, which severely curtail business activities. Higher precautionary holding of liquidity and play-safe mode behaviour of businesses lead to cash hoarding. This explains the spurt in currency demand. Unless remedies are adopted to rebuild trust, these consequences will be long lasting as self-construction of trust evolves slowly. 
Payment System Contagion
TC backlog dues are not received even after relaxation or un-lockdown in many cases. Trade debtors’ willingness to pay has nosedived. Willingness to pay past dues has evaporated. Survival instinct propped up by crisis environment and uncertainty compel businesses to consolidate their own financial position. With counterparty risk spiralling into a pandemic and many customers not making payments to vendors, many players move to safe-mode and are reluctant to release cash. The dynamics of non-payment of trade debts cascade into a payment system contagion. 
TC payment system is critical as without it most transactions cannot occur. There is dramatic and unprecedented plunge in TC related transactions and payment volume. Now most of the B2B deals are preferred or done on cash-and-carry basis. Credit indiscipline in the TC system acquires the characteristics of a crowd psychology. Firms are becoming indifferent to or abandoning their responsibility in honouring the rules of the TC eco system.
These create uncertainty and loss of confidence in TC, forcing changes in TC behaviour. 
The invisible cost of heightened business trust gap is very high in terms of business deals not effected, goods not produced, capex not undertaken and firms not started, as businesses anticipate that they cannot fully rely on counterparties’ commitment. Institutional settings and its characteristics do matter in trust formation. Without trust, financing and economic activities are crippled. It leaves a void, generating crucial vulnerabilities for trade, industry and financial sectors. 
This is an unprecedented phenomenon. It is beyond text book theories. As such, policy makers, academia and businesses themselves are oblivious of the serious implications of TC triggered and self reinforcing economic, credit and liquidity crises. Comprehensive analysis of financial markets and payments systems is the first step to effectively identifying and assessing systemic risk. 
Implications of Cash-and-Carry B2B Transactions
When trade creditors have difficulty in anticipating default/delay risk arising from liquidity crisis or opportunistic behaviour by a trade debtor, they become cash-focused and safety and security oriented. Further, falling sales compel firms to hold more precautionary cash balances relative to payment. Cascading effects of disruptions in TC flows and high liquidity holdback sequentially transmitted along the supply chain as amount and tenure of receivables are directly related to payables. Volume and value of economic transactions reduce.  Payment system is critical as without it most transactions cannot occur. 
Emergency Credit Line Guarantee Scheme 
This near automatic credit guarantee scheme for Rs3 lakh crore is a very good credit or liquidity boosting plan for MSMEs and small businesses. Its limitations emanate from the fact that only about 10% of MSMEs have bank credit outstanding. For 90% of the firms, TC remains the-lender-of-the-last-resort. Secondly, circulatory or multiplier effect of bank credit depends on the depth and length of its sequential flows through the TC chain which has become dysfunctional. Higher liquidity holdback and deterioration in credit repayment culture impact the credit multiplier. When the credit multiplier falls, it becomes tough for the economy to sustain growth. 
Pump-priming economy through higher bank credit to MSMEs, public expenditure, monetary easing and external fund inflows without addressing the fragility of TC could easily prove to be short-lived, less effective and efficient. The problem of credit-constraints for the sector needs to be addressed differently than the bank-focused approach hitherto. 
Industry associations (IAs) and business chambers can play key role in in overcoming the trust crisis by maintaining integrity and engendering transactional trust and confidence in the TC eco-system. They need to assume a leadership role in pushing self-regulation or self-discipline to meet the business-ruining challenges arising from the Corona crisis. These are essential for business survival as never before.
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 as compared to legal remedies. Their knowledge of working of business deals, reputational weight and moral authority can work more effectively and efficiently. 
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 bring institutional discipline in the B2B credit dealings. It may accredit select IAs which can work for self-discipline or self-regulation and prompt payment. 
TC eco-system improvement measures can greatly solve the perennial credit-constraint issue of MSMEs and Corona-led business crisis. It is relatively an easy, effective, efficient, faster and compatible solution for business revival without revenue sacrifice. These can facilitate free flow of credit - a necessary condition for resurrection of trade and industry and the progress of Atamnirbhar Bharat. 
Besides higher bank credit flows, we need to pump up the prime TC system. These measures include identification of breaks in the credit flows and devising trade finance interventions to prevent disruptions in supply chain financing and liquidation of viable and efficient firms due to liquidity crisis. Other measures may include, accelerated payments of dues by government departments/corporates, adoption of a prompt payment code by firms, boosting receivable financing, and mandated reporting of late payments.
(This is concluding part of a two-part series)
Read first part here…
(BL Chandak is former Deputy General Manager of SIDBI)
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