The idea that a society’s well-being is influenced by its economic institutions dates back to Adam Smith. This year, the Economics Nobel was awarded to Daron Acemoglu, Simon Johnson, and James Robinson (AJR) for their research demonstrating the link between economic and societal institutions and the level of prosperity. By institutions, the laureates refer to the broad set of rules and norms that govern the economic behaviour of businesses and society or a nation.

An example of the impact of institutional differences can be seen in the high income disparity between Nogales, Arizona, US, and Nogales, Sonora, Mexico, despite sharing the same geography, climate, and culture across the US-Mexico border. A similar contrast exists between South Korea and North Korea. These obvious intra-community inequality is explained by AJR in terms of differences in their political and economic institutional framework.

An example of a successful social institution is the Marwari community. Despite operating within the same geographical area with common economic and political institutions as other Indian communities, the Marwaris have achieved remarkable economic prosperity.

Trust-based credit

A key factor for this lies in their informal institutional framework, which enabled them to leverage trade credit effectively. Trust is the cornerstone of trade credit. Intra-community extension of trade credit relied on extended family ties and relationship, acquaintances, and referrals by respected and distinguished business and community figures.

This trust-based credit network helped them in establishing and expanding their businesses when banking was absent or inaccessible. Such familial business relationships not only provide credit but extend advice and strategic partnerships. It minimises credit risks and maximise opportunities.

Historically, trust in B2B credit relationships was reinforced by a strong social and business stigma against default and bankruptcy. Within tightly-knit communities, the fear of reputational damages and social boycotts — such as avoiding marriage alliances with bankrupt families — created strong pressure to honour financial commitments. These factors acted as powerful deterrents to defaults.

With changing social values and weakened societal bonds, and events like demonetisation and the Covid-19 pandemic, the trade credit ecosystem has been disrupted, eroding the willingness to honour financial commitments. Intense competition and the loosening of close-knit social ties have diminished the effectiveness of fear of reputational damages leading to widespread delays and defaults. These undermine payment culture - once key to business prosperity.

Businesses thrive on reputation, which is deeply tied to credit discipline. To operationalise this, real-time tracking of payment defaults and delays, along with the digital dissemination of this information to stakeholders, can foster a trade credit ecosystem.

The writer is former DGM, SIDBI

Related Topics