Tuesday, October 6, 2009

Lack of credit availability for small corporates threatens trend growth

Small and mid-sized businesses are an important part of most economies. They are responsible for providing the largest share of jobs and more importantly job growth and are also credited for significant innovation. In turn, they are a key driver of growth for an economy. If it gets more difficult to open up new businesses, then that promises to slow down growth to a significant extent. Certainly, there are numerous factors impacting the rate at which new businesses are being formed, ranging from the economic outlook to bureaucratic obstacles and many more. Additionally, access to external financing is frequently a necessary condition in order to be able to start a new business. However, here the news - especially out of the US - is far from encouraging.
While large enterprises do have access to the capital markets for external debt financing and debt issuance has been running high this year, small and mid sized corporations are much more dependent on bank lending. For the US, Meredith Whitney in this article entitled The credit crunch continues states that: "Access to credit is being denied at an accelerating pace. Large, well-capitalized companies have no problem finding credit. Small businesses, on the other hand, have never had a harder time getting a loan....Small business loans are hard to find, and credit-card lines (a critical funding source to small businesses) have been cut by 25% since last year." She then goes on: "In the U.S., small businesses employ 50% of the country's workforce and contribute 38% of GDP. Without access to credit, small businesses can't grow, can't hire, and too often end up going out of business...Small businesses primarily fund themselves through credit cards and loans from local lenders. In the past two years, credit-card lines have been cut by over $1.25 trillion."
If existing small businesses cannot get access to bank credit and given their size cannot access the capital markets directly, their owners have either to invest more or they face increasing risks of a liquidity shortage which threatens to force the company into bankruptcy. Furthermore, if credit for small-sized business is very hard to come by, then it will be more difficult to found a new business. In turn and as mentioned above, the job creation by new businesses slows and also the flexibility of the economy suffers.
However, job creation by new businesses as calculated by the Bureau of Labour Statistics does not mirror this reality. The chart below shows the development of the so-called birth-death adjustment. This adjustment should indicate the jobs created by new businesses minus the jobs lost by business closing. Given that the BLS estimates the data via statistical analysis based on historical time series it has been causing doubts about the reliability of the payroll report numbers. In short, the BLS uses an estimation procedure with two components: the first component excludes employment losses from business deaths from sample-based estimation in order to offset the missing employment gains from business births. This is incorporated into the sample-based estimate procedure by simply not reflecting sample units going out of business, but imputing to them the same trend as the other firms in the sample. This step accounts for most of the net birth/death employment. The second component is an ARIMA time series model designed to estimate the residual net birth/death employment not accounted for by the imputation. So effectively, it is largely based on longer-term historical data and not on actual (hard to measure) job gains and losses.
The data below are not seasonally adjusted and always show a large drop in January followed by an upsurge into spring and moderate payroll growth in H2. Since the start of 2007, the accumulated birth-death adjustment is not showing a trend change (it is up by more than 2mln jobs over the past 2.5 years). Given the difficulty for small businesses to obtain credit - and therefore higher hurdles to start a business - this does not seem plausible at all.
BLS birth-death adjustment does not show a slowing trend
Source: BLS
In turn, as the birth-death adjustment most likely overstates job creation by new businesses, job destruction in the current recession looks understated. Furthermore, I do regard the increasing difficulty to open new businesses as one reason why trend growth in the US is likely to slow markedly for the next several years as the flexibility of the economy is being reduced. The only positive aspect I can see behind this is for existing businesses with enough liquidity as they do face a lower risk of new entrants eating away market share and/or cutting into their margins.

Interestingly, according to the Ifo institute the situation in Germany is different. According to their latest survey (released on Sep 29, see here): "Credit constraints for German trade and industry weakened slightly in September. Of the surveyed firms, 43.7% now assess bank lending polices as restrictive. In August 44.2% of the survey participants complained of difficult access to bank credit. However, there are differences among the economic sectors of the survey. Of special note is the favourable development in wholesale/retail, where the credit hurdle fell from August to September from 41.7% to 39.9%. In construction the lending situation remains unchanged. A different tendency is observable in manufacturing. Here the bar of the credit hurdle rose from 45.9% to 46.5%. For large manufacturers in particular, the credit hurdle was again higher, from 51.8% in August to 54.5% now." As the chart below shows this survey suggests that small and medium-sized businesses face less tight credit conditions than their larger counterparts. Usually, this is just the other way around. Furthermore, compared to the 'German crisis' in the earlier part of this decade, overall credit conditions for small and mid sized manufacturers do not appear overly tight.

Credit constraints in German manufacturing according to company size
Source: Ifo Business Survey

But why do we see such a difference between credit availability for small and mid sized corporates in the US and Germany and what is it telling us about the likely economic prospects?
First, in general especially small corporates are very much a local affair and depend on the state of the domestic economy whereas large corporates usually have large sized international operations and are therefore more export dependent. Given that the outlook for consumption is bleak in the US and because bank balance-sheets are still far from healthy, banks seem to shy away from increasing their credit commitments towards domestic operations. This is also what happened in Germany earlier this decade. The weak state and outlook for the domestic economy let banks be especially restrictive with credit for the smaller locally-focused corporates whereas the export-oriented larger manufacturers had much easier access to credit. However, given that the situation in Germany's export markets deteriorated significantly, the export-oriented corporates seem to be facing a tight credit environment. The locally-oriented small/mid-sized businesses on the other side as well as the wholesale/retail industries face a relatively better economic outlook given that there has been neither a housing nor a consumption bubble within Germany. In order for the German economy to shift its focus away from a very high export dependency towards a larger domestic focus, relatively easy credit availability for the domestic-economy focused companies is a necessary - but again not a sufficient - condition. The news on this front at least looks promising.

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