Monetary policy’s blinkered view of credit
The RBI’s frequent shifts in policy relating to bank lending rates over the last 25 years — starting with the PLR in 1994, the BPLR (2003), Base Rate (2010), the MCLR (2016), and now, external benchmarking — reflect policy rate uncertainty. Leaving aside the market rates, even banks’ lending rates remain at variance with monetary policy intents. Growing financial sector instability/vulnerability, growth uncertainty, credit-constrained MSMEs, low farm prices, surplus liquidity with banks as against unprecedented liquidity constraint with businesses and a high level of cash in the economy despite digitisation reflect poor monetary policy outcomes.
How did we get to such adverse conditions? Why is the financial sector more vulnerable now than ever before, despite the experience/expertise gained by the RBI over the last 25 years, the advent of monetary-model based policy analysis and economic forecasting, and Big Data analytics?
One of the key reasons lies in the bank-centric monetary policy framework. It misses out on the systemic role of the trade credit channel in defining monetary policy transmission (MPT). A guesstimate of working capital requirement based on the turnover of 94.3 lakh firms which filed income tax/service tax returns for FY14, the outstanding working capital of banks and miniscule bank working capital flows to the unorganised sector show that banks meet less than one-third of the aggregate working capital needs of businesses. A monetary policy architecture which built on a narrow, bank-centric base cannot be stable and sound.
A partial view of MPT can lead to erroneous/deceptive conclusions about the working of the monetary policy. Anecdotally, the RBI’s assertion of bank liquidity in surplus is deceptive when businesses are reeling under an unprecedented liquidity crisis. Non-bank credit, especially trade credit, is the predominant source of working capital across businesses. Trade credit is an equally, if not more, important channel of MPT as a bank.
Trade credit is the largest credit intermediary — far bigger than the banking network. World over, trade or B2B credit sales are the single largest common source of short-term business credit. In terms of credit volume, reach and supply chain financing, trade credit is far bigger and inclusive than bank credit. It provides market, funding and transactional liquidity.
According to the Association of Chartered Certified Accountants, London, trade credit supports almost half of B2B transactions globally. Dun & Bradstreet’s study of 9,600 companies in India shows that these companies’ account payables and short-term bank credit to total liabilities ratios were 12.3 per cent and 8.6 per cent respectively for FY11.
The RBI’s annual sample studies of financials of non-government, non-financial public limited companies’ sundry creditors and short-term bank credit to total liabilities ratios averaged 12 per cent and 10 per cent, respectively, during the 1991-2010 period.
Only 5-10 per cent of MSMEs have working capital from banks. Predominance of certain business communities in trade and industry is due to trade credit financing.
Trade credit re-intermediates bank credit and suppliers’ credit by creating a credit intermediation chain. The World Bank advocates trade credit as an important tool for channelling credit by large /liquid firms to MSMEs.
Bank working capital ultimately transforms into trade credit; the two form interdependent and inter-locked functional links along the supply chain financing network. The transaction financing role of trade credit is similar to that of currency and bank demand deposit.
A firm’s bank credit need is greatly determined by volume and tenure of its receivables and payables. Bank credit growth, its multiplier and the effectiveness of MPT crucially depend on the working efficiency of the trade credit system.
Inclusion of the trade credit channel in the monetary policy framework helps in better understanding of the response of output/demand to policy measures and complexities of the MPT working mechanism.
Agglomerative effects of millions of day-to-day trade credit transactions, as well as their role as last-mile links in credit creation and distribution on macro credit aggregates, are very large.
Trade credit influences the total volume of liquidity flowing to the business sector and its allocation across firms. Market interest rates are also to a great extent determined by its demand and supply.
Credit velocity is dependent on the length, depth and strength of the credit chain, which itself is dependent on the sequential trade credit creation by firms along the supply chain.
When trade credit is working well, it goes largely unnoticed. But once it is taken away, and supply chains, the payment system, liquidity, credit flows and growth are disrupted. The sudden immobilisation of a good part of trade credit financing — which comes from unaccounted/informal business capital/funds — following demonetisation and the implementation of the GST has left a large gap in trade credit flows.
The chain effects of such a disruptive event are quite extensive, complex and excessive. These include the unprecedented liquidity crisis, the spurt in credit-related delays/defaults, disruptions in the supply chain financing network and disturbances in the payment system.
The fear of delay/default, the need for hedging against uncertainty in cash flows and the risk of credit rollover lead to higher liquidity hold-back. These further aggravate the liquidity crisis. Over the years, the growing trust deficit, the weakening of trade credit practices/conventions and changes in the credit culture — from being ethically committed to honour debt commitments to indifferent, opportunistic behaviour — and a decline in perceived reliability/creditworthiness in general add on to this crisis. Lower business confidence and capex follow. All these aggravate the economic crisis, despite sound macro fundamentals and monumental reforms.
The monetary policy should take an integrated view of both bank and non-bank credit channels. Greater understanding of the trade credit network’s role in MPT, manifestation of its behaviour under the financial crisis and the role of trust and confidence channels in aggravating the liquidity crisis are needed to analyse the growth-impacting factors. Without attending to trade credit issues, it is difficult to solve the problem of the liquidity squeeze.
Restoring the full circularity of informal/unaccounted business funds by formalisation is necessary. This is a practical solution to the large-scale liquidity gap across businesses. Rationale and framework for this are discussed in my previous article (see BusinessLine, February 10).
We need to identify the hurdles/gaps in the credit flows and devise trade finance interventions to prevent disruptions in supply chain financing. Trade credit’s role as the lender of last resort needs to be strengthened to provide financial stability to un-banked firms. Emphasis on bank liquidity/credit flows alone can be an oversimplified and inadequate response to the crisis.
The writer is a former DGM of SIDBI