Old habits die hard: Informal finance in Andhra Pradesh stuck on cash despite demonetisation

In the 50-odd days since the demonetisation announcement, several instances of its unintended consequences have surprised its proponents as well as opponents.

One fond hope of demonetisation was that it would boost cashless, or electronic payments, and help the push towards formalisation of the economy. The advantages that would accrue through this push towards formalisation are often cited as one of the main reasons for demonetisation.

The fact that the economic history of post-independence India is replete with examples of a gradual process of continuous expansion of the formal sector gives those who believe that demonetisation will push informal sectors into the formal economy reason for optimism. After all, a large part of the process of formalisation of the economy over the past seven decades was triggered by conscious policy interventions aimed at expanding the scope of the formal sector.

This article looks at the impact of demonetisation on informal lending and the chit fund business in different parts of Andhra Pradesh.

Though it is early days still, initial indications seem to belie expectations that demonetisation will dramatically alter the behaviour of participants in the informal sector by forcing them to abandon their past behaviour. In fact, there are indications that cash is rapidly making a comeback.

Initial shock

The informal finance business encompasses a large number of financial services that are very complex, highly segmented, and often highly-specialised activity. Each segment caters to a particular group with its service providers rarely venturing into another line of business. For example, a call money lender settling transactions at the end of the day will not lend to a person hoping to buy a vehicle on equated monthly instalments. The term “call money” refers to a form of informal moneylending that requires repayment of principal and interest at the end of the day. It is called call money since credit is delivered to the borrowers with one phone call, and at their doorstep.

Just as in the formal business segment, informal business is always affected by, and reacts in different ways to, external events. However, the difference is that the external factors tend to be more numerous in the informal sector than in the formal sector as it sees more rapid changes due to the localised scale of operations and nature of its organisation.

The initial reaction of participants in the informal finance business to demonetisation was one of shock and confusion.

In parts of the business, especially in the section that deals in small amounts (usually lending less than Rs 25,000), there was not much dislocation initially as many of this sector’s participants continued to accept the old high-value demonetised notes.

However, as availability of valid legal tender became tight, the dynamics in this business changed dramatically. Although borrowers were willing to settle their dues in old currency notes, lenders refused to accept these notes as repayment because of the scarcity of new notes.

Thus, all segments of the informal finance business were mostly paralysed two weeks after the November 8 demonetisation announcement as participants refused to accept the old notes, and the lack of smaller-denomination notes meant that the new Rs 2,000 notes could not be exchanged.

However, the larger players in the informal finance business, who often lend more than Rs 20 lakhs, were the exception.

In Vijayawada, in the aftermath of demonetisation, these bigger lenders lent money using a combination of new and old notes. The new notes were acquired by payment of commission to the bankers.

In the region, large-value lending in the informal market is often relatively immune to short-term external shocks since they are invariably backed by property collateral. These “sale registration finance” deals as they are often called, requires a borrower to complete the registration of a property as a sale to the lender before any money is lent.

Thus, in the case of larger lenders, since financiers often have sufficient collateral, there is little need to aggravate problems during an emergency situation by demanding immediate repayment. Instead, financiers prefer to maximise their returns since any delay in repayment means they receive more in terms of interest.

Repayments postponed

By the end of November, the most common response of the smaller informal lenders was to postpone their loan collection activities because they realised that attempts to force repayments would result in borrowers defaulting. This was particularly the case in rural areas.

Unfortunately, this meant that informal businesses lost access to their working capital needs as lenders were keen on limiting their exposure to risk.

Savvy borrowers, especially those who were finding it hard to repay their loans, were quick to take advantage of the situation by offering only old notes in repayment when they realised that their lenders, unwilling to accept demonetised notes, would wait if they were offered these notes as repayment.

In other places, like rural Kurnool district where business activity is linked to agriculture to a higher degree, and loans are smaller in size, financiers voluntarily agreed to defer the collection of principal and interest.

This happened because buyers of agricultural produce in the mandis and markets, who found it difficult to withdraw cash, issued cheques for commodities procured. But lenders were unwilling to accept payment through cheque or bank transfers, and insisted on cash, just like during pre-demonetisation times. Given the scarcity of valid legal tender in the economy following demonetisation, lenders therefore had no option but to offer an extension of the repayment period. At the same time, there was no writing off of two months of overdue interest. Only its collection was postponed.

Thus, in all the regions, across all segments of the informal finance business, the two-month delay in collection of repayment has meant an increase in the net outstanding obligation of the borrower.

Over the past 10-15 days, all categories of lenders have informed their borrowers that they expect their instalments to be paid in cash, and in full, from January. Thus, there is no real move to go cashless in this sector. It is back to business as usual.

Temporary impact

The chit fund business is more complex since it entails the participation and cooperation of a large number of people. Chit funds are a kind of a group savings scheme practiced in India in which a group of participants comes together to save a predetermined amount of money for a certain duration with an organiser. One participant referred to as the “prized bidder” gets to collect a percentage of the total money collected in advance as a loan on the condition that he or she will continue to repay the sum in monthly instalments.

The underlying characteristic of the chit fund business is the large-scale informalisation of what was once in the formal sector. A number of chit fund firms have recently either shut shop or have become inactive while their promoters have floated informal chit groups with participants cherry picked from their experience of running the formal firms.

Unlike informal lending and borrowing, which is essentially a transaction between a lender and individual, and sometimes a guarantor, the chit fund business is dependent on the participating group – which has between 10 and 25 members.

In the aftermath of demonetisation, prized bidders in chit fund groups refused to accept old currency notes as part of their loans, while other participants could not pay their contribution in new notes. This led to a temporary suspension of collection of money till the supply of currency notes increased.

In the past few days, most chit fund organisers have communicated to their members that business will resume as usual in January from the point it had stopped, and all payments will be only in cash.

Unlike in the moneylending business, members of chit fund groups are picked on the basis of the person’s ability to pay their instalment. This meant that there was less dislocation due to demonetisation in chit fund businesses in urban and semi-urban areas than rural areas as urban areas were better off in terms of remonetisation than rural areas. The inherent flexibility of the business – for instance there are no daily repayment collections and if payments are postponed due to the lack of cash only the prized bidder suffers as he or she has to pay interest for a longer period – also helps overcome shocks like demonetisation and there are very few instances of chit funds winding up because of demonetisation.

Can’t force cashless

Informal finance thrives due to the twin factors of convenience and flexibility that offer customers customised services at an unmatched speed. Importantly, informal finance survives only because there is cooperation between its providers and consumers. As long as this cooperation exists no amount of external shocks can shake the business.

Hence, though formal lending services as those offered by banks and other financial institutions may seem cheaper and less risky from the perspective of the government, not many people are likely to embrace these services even when forced to, unless they are made attractive.

In the case of Andhra Pradesh, it is clear that so far there are no incentives for participants in the informal finance business to change their behaviour.

Suppression of informal finance businesses by the government is unlikely to work due to the large number of participants in these businesses and because it is becoming increasingly difficult to isolate informal businesses without having an impact on the formal sector. In other words, it is difficult to claim that informal finance businesses operate beyond the complete purview of the formal financial systems. The two segments are more intertwined than is often thought and the line separating the two is not only fluid but is constantly changing.

There are no signs that the informal finance business is willing to forsake its pre-demonetisation practices either by embracing the formal sector or its practices. The fact that it is unwilling to do so even in the face of a severe external shock like demonetisation means that the government may have to look elsewhere for solutions for its formalisation drive.