Hundi (Chitti) – A failure or an Evolution? – Part 2 of 2

Setting the context from Part 1 on this topic - Hundi/Chitti denotes an unconditional contract for payment transfer, negotiable by delivery. It is essentially an unorganized and unsecured format of short-term lending that was used for carrying out trade and commercial transactions, especially amongst the Baniyas community.
But today, this unorganised financial market that once contributed significantly to the economy is in shambles because, post demonetisation, Lenders are severely affected because some borrowers are failing to give back principal but serving interest and asking for time to repay the principal. Some of them have failed to pay even the interest on the unsecured loans. This has affected HNI and other individuals from all walks of life including those who had lent their small life savings / retirement money.
If we were to decode the landscape that has led to such defaults -

Is it Niyat (Integrity) or Is it Circumstances?

A common misconception doing the rounds is that - "Logon Ki niyatkharabhogayi Hai" (Borrower is a wilful defaulter even though he has the money to pay). Let me ask one thing, if 20 out of 100 have defaulted on their payments, "Sub Ki niyatkharab Hai"? (Are all 20% wilful defaulters?). I can guarantee you that is not the case. We live in a society where reputation plays a big role in a family’s future. Unless someone is OK leaving the city / country, and leaving behind everything they know, no one wants to be labelled a defaulter. 2 out of that 20 could be wilful defaulters who are ok living with a bad reputation but the rest 18 have fallen because of circumstances and poor financial literacy.

Is it an imbalance between Profit and Interest?

A simple rule in business says, If the profit is more than the interest being paid on the loan, no one wants to default? The problem today is that the profit is less than interest being paid and during an economic downturn, something extreme that we are facing right now, most problems in the system get magnified multiple folds. Most small and medium business owners have limited financial literacy. In lot of cases business owners don’t even know if they are making a profit or loss every month. Most of them just go with the flow and expect to come out ahead at the end. Lot of them do come out ahead but during an economic downturn, it becomes difficult to come out ahead of the problems.

Is it lack of financial Acumen amongst the borrowers?

Most borrowers do not have the financial literacy and fail to understand that they are borrowing to repay past losses. These string of borrowings causes a vicious downward accumulation of bad debts (A debt that is not producing any income but causing losses every month. Most small business owners fall into this trap unintentionally because they lack financial understanding and high emotional attachment with their business and livelihood. This keeps them from shutting down and forces them to keep on borrowing making situation worse till someone is willing to lend causing more losses hoping they could revive one day.

Is it a fall out of Demonetisation?

Debt Rollover (Chakri / Topi / Evergreening): Basic premise of Short - term lending (Hundi / Chitti) was that at the due date the debt could have been rolled over ("Chitti renew hojaayegiya koi aur dedega"). Demonetisation on November 8th, 2016 brought in front massive issues plaguing the system. It became very difficult for borrowers to roll over the short-term debt as number of people willing to lend has gone down drastically in this troubled market. This causes a chain reaction where non - rollover of debt causes more defaults and makes market sentiments worse leading to less lending and further defaults.

Are borrowing levels under- leveraged to generate adequate momentum?

Actual need is higher than what the borrower is able to raise in a troubled market. Let’s assume a business owner requires 1 Crore for his business as working capital. If he is only able to raise 50 lakhs in the 2 or 3-month period he is looking to raise funds, the 50 lakh he is able to raise probably will lead to more losses than profit for the business as need is higher and funds are less. In most businesses, once funds are put in, it is very difficult to take out that money without affecting the growth of business.

Diversion of Short-Term funds to Long term investments?

Most borrowers in good times made a crucial mistake that I call cardinal sin of finance. Diverting short term funds towards fixed assets (Land / Building / Machinery). Many borrowers borrowed money to purchase / build physical assets. In good times, it is easier to hold / sell the fixed asset that is expected to appreciate but during tough times like we are facing right now, it is very difficult to monetize these assets. This coupled with failure of debt rollover causes borrowers to default on their repayment commitments as the funds are stuck in some asset that cannot be monetized and the borrower does not have enough liquidity to cover the debt repayment or the interest payment on the debt.
Well, while all of the above factors have somehow been driving forces behind Hundi/Chitti’s phased system failure, need of the hour is to address concerns about -
• Globalisation of trade and commerce warranting financial instruments that can align internationally.
• Multi fold increase in volumes of hundi transactions making it almost impossible to integrate with banking systems.
• Need to bring about tax regulations aligned with economic reforms and the inability to capture levy on informal financial instruments.

Is an Ecosystem of Co-investor and Entrepreneurs led by Lead investor the much-needed alternative?