One year after Prime Minister Narendra Modi mounted what was hailed as a “surgical strike” on black money by invalidating 86% of currency notes in circulation, India’s informal credit systems remain disrupted. This has resulted in a scarcity of working capital, a situation that has been compounded by the introduction on July 1 of the Goods and Services Tax. This combination, experts say, has proved to be a great drag on India’s economic growth.

Economist Pronab Sen, India’s first chief statistician, estimates that the quantum of informal credit in the Indian economy runs at about 25% of the level of formal credit. But the multiplier effect of informal credit is much greater than that of formal credit, Sen told As a result, the tremors in the cash-dependent informal credit system have sent shockwaves through the economy.

Informal credit refers to loans obtained through social networks, often without presenting collateral, usually at a higher rate of interest than banks charge. People typically resort to taking informal credit to tide over a temporary liquidity crunch. Trust is a vital asset in securing informal credit – the lender has faith that the borrower will repay the loan. But Modi’s war on black money was so severe, it led to a veritable meltdown of the informal credit system.

Forms of informal credit

There are four principal modes of informal credit.

Borrowing from the market: The most dominant from of informal credit, in business parlance, is described as “borrowing from the market”. The lender is a businessperson who possesses surplus cash, mostly undeclared to the tax authorities. The borrower is part of the lender’s social circle. In some cases, a broker who enjoys the lender’s confidence may have secured a loan for the person who needs it. The lender and the broker have a fair idea of the borrower’s income and his credit history. Unlike in the banking system, no documentation is required.

The interest on loan depends on the lender’s level of trust in the borrower. In market parlance, the interest would be stated thus: Re 1 per lakh per month. It means an interest rate of 1% a month or 12% per annum. Before demonetisation, the interest rate varied between 12% and 18%, but could be lower for special clients.

Forming committees: Another mode of accessing a loan is to float a committee. An organiser bands together, say, 20 people who contribute Rs one lakh a month. Bids to take the money are received every month. If person Y requires Rs 20 lakh, he tells the committee that he will return Re 1 lakh for 23 months. The Rs 3 lakh extra that he pays becomes interest earnings for the 19 persons, who divide the amount among themselves. However, Z could outbid Y by offering to pay Rs one lakh for 24 months.

Credit on raw materials: The third mode involves supplying raw material on credit for production. Take the carpet industry, where the manufacturer sources yarn from the supplier. Typically, the yarn supplier provides the raw material on credit or part-payment. He charges a marginally higher rate for the material given on credit. The supplier-manufacturer relationship is built over years.

Commission agent: The fourth mode of informal credit is represented by the commission agent or arathia. In rural India, farmers can avail of bank loans only if they have land to mortgage. Farmers who take land on batai – either paying rent to the landowner or giving him a share in the produce – do not qualify for institutional loans. This is where the arathia comes in.

“It is the arathia who provides seeds, fertiliser and even money to sharecroppers,” said VM Singh, Convener, All-India Kisan Sangharsh Coordination Committee. “After the harvest, the arathia buys the produce of farmers, deducting from the sale proceeds the cost of inputs and his margin of interest. There is no collateral demanded because, often, there is none to provide,”

Even owners of cold storage facilities loan money farmers, as is common among potato farmers in west Uttar Pradesh, at every stage of cultivation, from sowing to harvesting. In return, farmers sell their produce to cold-storage owners, who then deduct the principal amount and interest from the payments previously made.

The meltdown

This world of informal credit, although inherently exploitative, was stable and helped lakhs of Indians conduct their businesses in the absence of access to formal banking facilities. But Modi’s demonetisation shook the very foundation of this system.

Lenders’ cash tranches were reduced to worthless stacks of paper overnight. Their worries were compounded because their borrowers wanted to return their loans in old currencies. Of course, many lenders managed to convert old currency notes into new ones – but at a cost. They took hair-cuts, often forfeiting 20%-30% of its value. As a result, their Rs 10 lakh shrank to Rs 8 lakh or Rs 7 lakh.

Credit: Noah Seelam/ AFP

Debtors also faced an unexpected problem. When they took their loans, they had not anticipated the shock of demonetisation and how it would freeze their businesses. Many had to extend their loan period, and pay more money as interest. Some defaulted on their loans. Likewise, committees collapsed because members were unable (or unwilling) to pay their monthly share in new currency notes.

This weakened the very foundation of the informal credit system: trust. The social circles linking lenders to borrowers collapsed.

Loans have not completely stopped, of course, but now credit is being extended only to the select few who enjoy the complete faith of lenders. A businessperson who did not wish to be identified said, “We now prepare an R&D [research and development] report before lending.”

Demonetisation has also unleashed a sense of anxiety. A government that can suck 86% of currency out of the system overnight is capable of worse, businesspeople say. This has prompted lenders to be wary and secure their stocks of cash.

“The lender whose cash tranche has been reduced from Rs 10 crore to Rs 8 crore will park, I think, Rs 5 crore in gold, diamond, foreign currency, and even real estate, despite it no longer being a lucrative investment proposition,” said a businessperson from an industrial city of Uttar Pradesh. “He will guard the Rs 5 crore as closely as he does his children. This means the lender has only Rs 3 crore to spare, and this too will be given to whom he trusts absolutely.”

Speculation about the government’s potential next moves have got rural India worried. Income Tax notices served to arathias have dampened their enthusiasm to advance cash to farmers. This is also the case with cold-storage owners.

Under these circumstances, farmers will raise money from other sources at higher interest rates. Rural indebtedness will grow. Already the rent of land leased for sharecropping has dipped sharply in parts of West Uttar Pradesh. Consumption is likely to fall, further depressing economic growth.

The monster called GST

The squeeze on informal credit has overlapped with the implementation of Goods and Services Tax, which requires tax to be paid upfront every time goods change hands. This tax is to be adjusted the next month, locking in the businessperson’s working capital. A Times of India report cited this as the reason why Rs 2 lakh crore working capital of businesses has been stuck with the government since the launch of GST in July.

Earlier, all those short of working capital would raise money from the market. But lenders have become picky about whom they lend to. They think it is better to be safe than to be harassed by the authorities or end up in jail. The interest rate for informal credit is now down in the 9%-12% range.

The debilitating impact of the paucity of informal credit can be seen in the carpet industry, said Gaurav Kapoor, a young entrepreneur based in Varanasi, which is the prime minister’s constituency. The industry has three principal players – manufacturers, contractors and yarn suppliers. Manufacturer would place orders with contractors, who would procure the yarn from suppliers, on credit or part-payment. A large chunk of these dealings were in cash.

But now, whenever the yarn changes hands, GST has to be paid. This means that if a supplier advances credit to a contractor, a supplier still has to pay tax on the entire amount. His requirement for working capital will grow. No doubt, he can charge a higher interest rate on the line of credit extended, but it enhances the burden on the contractor. Rather than bear the increased cost, many contractors have chosen to scale down their economic activity.

“Both demonetisation and GST have wrecked the informal credit system and, therefore, threatens to sink the carpet industry,” said Kapoor.

Credit: Raveendran/AFP

To the bone

The meat industry, already weakened because of increasing attacks from gau rakshaks, has been further wounded by demonetisation and GST. Before demonetisation, agents would buy cattle from farmers in cash and bring them to meat plants or mechanised abattoirs.

After demonetisation sucked out the cash, the cattle trade continued because farmers sold their animals on credit. But as soon as the meat industry showed signs of partial recovery, GST was introduced. “Earlier, hide, offal, bones were all traded in cash,” said Imran Qureshi, who owns a meat plant in Meerut. “These are all now in the GST net. But people don’t have the working capital to pay tax, wait for the refund, and also extend credit. Some meat plants have closed down and those functioning are working at 45%-50% capacity.”

This has resulted in a rise in unemployment. In West Uttar Pradesh’s Sambhal district, three meat plants have closed down over the last one year. It has ballooned the army of daily wage earners seeking work and has depressed the daily wages.

It cannot be anybody’s case that there should not be war on hoarders of black money and tax evaders. But cash was, and still is, the invisible hand that turned the wheels of the Indian economy. Has the cure become worse than the disease? “The Prime Minister is following the business model of the West,” said Ateeq Ansari, sari manufacturer and social activist in Varanasi. “The problem is that when you give Size 7 shoes to a person who wears Size 5, he will only drag his feet and slow down.”

This is precisely what has happened to India’s economy.