independent

Friday 18 April 2014

Big deals are meaningless if people are waiting for credit

THE other day, a woman stopped me on Wicklow Street and asked: "If there is so much money around for the big things, why is there so little money about for the little things?"

As far as she was concerned, if the ECB and the Government could somehow find tens of billions to finance bank bailouts, if they could find a way to roll up huge debts and put these debts on interest only for decades before principal was paid, why couldn't they do the same for her loans of mere thousands?

Nor could she figure out, if so much money had been funnelled into the banks by now, why couldn't her small company borrow a few thousand euro from these same banks?

These are fair questions and they sum up the gap between the apparent lack of credit on the ground and what is happening in the world of international finance, where we see huge deals like the recent Anglo one and, on the same day, Michael Dell borrowing €26bn to take his company Dell Computers private.

This disparity is one of the central dilemmas facing not just Ireland but many other economies, too.

While very big deals are getting done in the world of international finance, very small ones are curtailed in the world of local business.

The conundrum is that, ultimately, the credibility of the big deals can only be based on the effectiveness of thousands of tiny deals that grease the wheels of the economy. If the small businesses are not getting enough finance, the economy won't grow. Therefore, the growth projections, upon which the big deals are based, could falter, undermining the central assumptions of these mega-deals.

At last year's Global Irish Forum in Dublin Castle, one of the American delegates made a valid point when talking about the credit crunch for small companies. He noted that it wasn't so much that small companies hadn't enough credit, they hadn't enough customers as well.

Both customers and credit are related, and the lack of both can be explained by what Keynes called a "liquidity trap" in the 1930s.

This is when interest rates don't work. In fact, Keynes famously described cutting interest rates in a liquidity trap as being as effective as "pushing on a string".

In normal times, when interest rates fall, those with savings decide that there is no real return on savings, so they spend instead. In addition, while there are many savers who just don't want to spend, their savings don't stay in the banks' vaults, this money is recycled by the banks and lent out to those who want to invest and spend.

This is a central role of the banks in the economy. When they are working properly, they match savers and investors, keeping money flowing around the economy. For this circular flow of cash to run smoothly, you need people who want to invest, people who want to save and banks that bring both together. But what if one or all of these pieces of this jigsaw is not working?

What if the people are carrying too much debt and, even at low rates of interest, they don't want to borrow?

Or what if the people in debt choose to pay back the debt they already owe, irrespective of the rate of interest? Or what if the banks are carrying too much bad debt and they don't want to lend?

In this case, it doesn't matter how low the rate of interest goes, it won't kick-start lending and investing and the economy gets stuck.

This is what the lady on Wicklow Street was referring to. She couldn't figure out how there were billions available for the banks and nothing for the banks' customers.

The core of the problem is that the money is getting stuck in the banks. It is not because the banks don't want to lend. After all, that's how banks make money; without lending they have no business.

It is because there are so many loans still going bad and the banks have to cover these non-performing loans with cash and then don't have enough cash to lend out.

While these types of problems are being faced by small companies all over Europe, a quick look at a recent ECB and Central Bank survey shows that Irish SMEs are facing credit conditions significantly tougher than the euro-area average.

According to the ECB, the share of Irish firms reporting increased interest rates was 15pc higher than the euro-area average, despite the fact that interest rates have never been lower.

Also, non-interest costs of finance, such as fees and charges, have increased 7pc more for firms in Ireland than elsewhere.

Meanwhile, the size of loan available decreased by 28pc more for firms in Ireland than the average.

As the banks are terrified of loans going belly-up again, collateral requirements increased 12pc more for Irish firms than the average.

The result is that rejection rates for loan applications are 48.6pc in the Irish data, as opposed to 21.3pc on average in the euro area.

Not surprisingly, demand for bank credit in Ireland is marginally lower than the euro-area average, with demand for overdrafts and trade credit above average.

But here is the problem: loan performance data shows that 30pc of Irish SME loans were either in default or were in arrears.

There is significant variation in loan performance across sectors of activity. But as you would expect, hotels, restaurants, construction, wholesale and retail are the large sectors with the highest share of non-performing loans.

And evidencing the splurge in the boom, the larger the initial loan, the more likely it is to be non-performing in all sectors.

As the great British economist John Stuart Mill noted, "the crash doesn't destroy wealth, it merely exposes how much wealth has been destroyed by stupid lending and borrowing in the boom period".

For all this to end, bad loans will have to be written off completely or written down to levels where the debtors can pay.

This will have to be done quickly because the longer we prevaricate, the more the woman on Wicklow Street will wait for new credit.

Without new credit, there are no new customers and we bounce along the bottom.

In order to cleanse the balance sheet quickly, the banks need sufficient capital to absorb these losses on bad debts.

The banks were recapitalised last year to make sure they had enough capital to get on with the job.

Let's hope they got their sums right and, as they say themselves, past performance is not indicative of future results.

www.davidmcwilliams.ie

Irish Independent

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