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Cash Crunch portends unusual Volatility in Indian Supply Chains

The ongoing de-monetization measure in India (of rendering invalid the INR 500 and INR 1000 notes currently in circulation) has been received with mixed feelings and reactions. On one hand, the move is being lauded as a bold measure to rein in corruption and the black economy. While on the other hand, the sudden reduction in valid currency notes and the unfortunate delay in building up the money supply has led to a crippling cash crunch for the consumers, especially the masses. We are hearing horror stories of people lining up at the banks for hours and the daily limit of INR 2,500 just not being sufficient to meet the daily needs of the families. As a result consumer spending has taken a hit.

One wonders what the short and medium term implications of this cash crunch be for the supply chains across industries where the end products are consumer goods and services. Volatility in the Demand and Supply levels would be my primary concern if I were a Supply Chain Manager in India right now.

According to a recent BCG and Google study on India titled ‘Digital Payments 2020’, 78% of consumer payments in India are still cash based. A cash crunch of this magnitude would reduce consumption levels drastically in the near term (next 1-2 months). This will hit the first tier of sellers, especially the small retailers, really hard. They will end up with excess inventory. At the same time, since a large part of their buying (I do not have the exact numbers, but can guess) is also cash based, they will have less cash to buy their supplies. Both these factors will result in reduced order volumes and excess inventory for the distributors.

The above will reduce off-take of goods from the manufacturers, who will be saddled with excess inventory at their sites. Typically, manufacturing is always characterized by utilization and other batch size constraints. Hence, there will be limits to the extent that manufacturers can reduce their production level and the time they take to do so. This will also add to the inventory build-up.

The other groups that will get impacted are the 3rd party transporters. They hire out the trucks for transporting goods and most of their payments to the truck owners are also cash based. So, even if a retailer, a wholesaler or a distributor is willing to buy new supplies they will have a challenge to pay the transporters, because of this cash crunch.

In the immediate future (next 2-3 months) most supply chains will witness high levels of inventory build-ups upstream because of the above scenarios.

However, this cash crunch is not going to last forever. Prime Minister, Mr. Modi has requested the general public to bear with this pain for a period of 50 days, until Dec 30th. So, we can expect that the money supply of valid currency notes will gradually increase and hopefully by the end of Dec reach its pre-demonetization levels.

As money supply conditions gradually improve, the consumption levels will improve too. Not at the same rate though, especially for the not so essential goods (typically the white goods). There will be a lag, but if all goes well, the demand levels across all sectors will be back to the pre-demonetization level by March or April 2017. However, there will be other factors that will render predictions around demand levels extremely difficult. Behavioral factors such as pantry loading (buying in excess of daily demand for consumer goods, in the fear of repeat of cash crunch in the near future) and hoarding (stocking up by retailers and wholesalers with the hope of selling at a higher price as consumer demand increases) will result in high volatility on the demand side for most companies.

The real challenge for the supply chain managers is how not to fall in the trap of responding to such sharp demand volatility with knee-jerk and reactive supply responses. At a very high level, the only silver lining in this scenario is that, demand will be chasing supply and not the other way around. Hence the main cost will be in terms of additional inventory holding and not lost sales; and as we know, cost of holding inventory is usually less than the cost of losing a customer order.

Supply Chain managers need to recognize that changing manufacturing and procurement levels sharply (downwards first and then upwards) will pass on the nervousness in the system farther upstream and unleash the proverbial supply chain ‘bullwhip’ in its worst possible form. The consequence will not only be higher inventory, but the sharp rise in operating costs at all levels in terms of procurement, manufacturing and distribution costs. On the other hand, a gradual, measured reduction on the supply side over the next 2-3 months followed by a gradual build up in response to higher demand will come at the cost of higher inventory levels only.

The above scenarios of course are illustrated at a very high level of aggregation. The specific situation will be different in each industry depending on how essential the goods and services are for the end consumer. For example, the essential food industry is probably getting worst hit right now as perishability is a direct consequence of such inventory build-ups. They will be the first to recover as well as money supply in the economy improves.

But the fact remains that reactive supply responses to such high demand volatility scenarios will only result in high cost to the supply chains and ultimately for the Indian economy.