Alan Ahearne: Viable small firms cannot be left to drown in a sea of debt
Using cash to pay off loans instead of fuelling growth is strangling the SME sector.
THE Government last week announced a new credit-guarantee scheme to provide much-needed credit to small and medium-sized enterprises (SMEs). It is worth remembering that SMEs account for more than half of economic activity in Ireland and nearly three-quarters of employment in the private sector. Given the crucial role that small businesses are expected to play in our economic recovery, measures to boost new lending to the sector are certainly important.
But equally important will be efforts to help commercially viable small businesses deal with the debts that are already on their balance sheets.
Like many other parts of our economy, the SME sector is riddled with debt -- a hangover from the credit-fuelled boom in the past decade. Data from the Central Bank shows that SMEs, excluding financial services and property-related businesses, are shouldering €27bn in bank debt. Sectors such as retail trade and hospitality are especially over-indebted.
Many small businesses accumulated debt during the boom to expand on the basis of overly optimistic expectations for future growth in demand. These investments were revealed to be excessive once the spending bubble popped.
In addition, many small businesses or their owners borrowed heavily to speculate in property. These property-related debts now threaten the survival of otherwise viable businesses.
Ireland is not unique in this regard. Many countries have had credit booms and busts and have faced the difficult challenge of resolving debt overhangs in the small business sector.
Japan is an example of how not to do it. The bursting of the Japanese credit bubble more than two decades ago led to severe balance-sheet problems for businesses. Japanese policymakers and bankers took a "wait and see" approach, hoping that the economy would recover of its own accord. It didn't -- and consequently Japan failed to resolve the problem of unsustainable debts. The resulting fragility of the banking system, in turn, limited its ability to extend new credit and support economic recovery.
International experience shows how post-bubble economies can get stuck in a vicious circle of excessive debt and poor performance in the business sector. Often viable businesses are unable to grow, or even survive, because cash that should be used for reinvestment and developing the business ends up being used instead to service debt payments.
There are other less obvious ways in which unresolved debt overhangs choke off revival in small businesses. For example, the debt overhang acts as a disincentive for owners or new partners to inject fresh money into the business. Without these funds, new projects that might boost earnings and create new jobs are postponed. This market failure arises as the extra cash generated by new projects goes entirely to the bank to service the debt.
Similarly, owners of over-indebted SMEs may be tempted to increase cash drawings from the business, thereby draining the business of essential funds. It is hardly a coincidence that evidence shows debt restructuring leads to a decrease in drawings and wages paid to the owners and their family members. Resolving debt overhangs seems to increase owners' willingness to keep cash in the business rather than to pay it out to themselves.
It's not just the cash; there is also the question of effort. Small firms depend on the hard work and sacrifices of their owners. Without their blood, sweat, and tears, the sector would wither away. But a debt overhang can disincentivise owners if additional earnings from such efforts simply accrue to the bank in the form of higher service debt payments.
Facing debt overhang, business owners may feel they are "working for the banks". In extreme cases, overhang may induce so-called "strategic default" by borrowers. This usually damages the business -- and the bank's chances of recovering some of its money.
None of this is to say that small businesses that are economically non-viable should be propped up. The international evidence clearly shows that maintaining credit flows to non-viable borrowers reduces the profits for healthy businesses, which depresses investment and employment growth. In practice, a business that is unable to generate enough cash flow to meet day-to-day operating costs, even after restructuring of its business model, is unsustainable and should cease to trade.
But for over-indebted SMEs where the underlying business is viable, something needs to be done to resolve the overhang.
Consensual restructuring is often the best answer to distressed debt, at least in cases where the bank feels that the current owner is the best person to manage the business. Placing the company in examinership might also help the business to survive.
Alternatively, banks may decide to put the business into receivership or liquidation. Selling the business, or part of the business, free from debt to new owners preserves jobs and makes sure that our economy's productive assets are not wasted.
Whatever approach lenders and borrowers decide upon, what is important is that decisive action is taken to resolve the problem of debt overhang. A strategy of forbearance invariably ends up raising the cost of distressed loans to the banks and stifling prospects for economic recovery. Just ask the Japanese.
Alan Ahearne lectures in economics at NUI Galway
Sunday Indo Business