EEF blog

Demand or supply?

Is credit growth negative because people don’t want to borrow or because banks don’t want to lend? The monetary hawks and sado-masochistic austerity lovers emphasis demand implosion.

Everyone’s paying off their debts. Nobody wants to borrow. Those with cash are worried about the future. Banks can’t lend to companies that don’t want their money.

On the other side of the coin are beardy Americans who in between saying the printing presses should crank up again and fiscal austerity belts should loosen, are clear that banks should be a little less tight and stop holding out on our growing SMEs.

While I’m sure there’s subtlety to both views that their respective acolytes will flourish at the hint of a challenge, my own view is a bit more mixed than these sometimes starkly expressed poles.
Both demand and supply are holding back credit growth.

Adam Posen kind of said this in his speech last week – but he thinks supply issues dominate – in particular those naughty banks and the lack of competition and capital in their sector.

I think it’s demand concerns that dominate. With near unprecedented turbulence in global markets that's not surprising and neither can you blame companies for being nervous about committing capital to investment. Too many manufacturers we talk to say that though things are going okay for them now, the constant rumble of doom in the media makes them shy away from investing.

But just because demand is the main factor doesn’t mean supply side issues aren’t important too. Why is it that small and medium companies are the most likely to show a divergence between their investment intentions and their actual investment behaviour?

These are the guys most reliant on the banking sector to provide their external finance.

Bank of England statistics (and EEF's own survey) show that for small firms at least credit continues to get dearer.

And as the bank-funded SME Finance Monitor has shown, 15% of SMEs don't even get as far as receiving dearer credit - fearful of being rejected by the bank - or worse, having their existing arrangements made more expensive.

For the banks, smaller firms are the most likely to be discriminated against, given the costs involved in scrutinising them, their lack of track record if they’re new, and the lack of pressure banks feel from competitors to compete for business.

How you see the issue of access to finance has important implications for possible policy responses. If credit growth is solely a demand problem, then it’s very easy – particularly if you favour fiscal austerity – to say that nothing can be done.

If you see tight supply as having a role, even if you think addressing it will all our problems, you may still see a possible improvement via policy (or market) action to improve the flow of finance.

People like Posen and in the House of Lords, Lord Skidelsky, see a role for state-sponsored institutions in the banking sector. Skildelsky is conducting a round table on this matter in November.

I myself might not stretch to this – for a start I don’t think a new state-sponsored bank could be made very quickly without perhaps using the government's existing stocks in RBS - which would be disastrous for the share value. But the same concern with the supply side of access to finance is why I’ve been banging on about the need to move further and faster on enhancing market competition in the UK banking sector.

The IMF World Economic Outlook was released today. And it does not make for a particularly cheerful read. As Ed Conway points out in his excellent summary of the key points, the growth forecasts for the world as a whole have been revised down from 4.3% to 4% this year and 4.5% to 4% next year. Advanced economies are only expected to grow at 1.6% this year, revised down from the previous forecast of 2.2%.

And the main reasons for these revisions?

1) Increased commodity prices, in particular the impact of geo-political tensions on oil prices
2) Sluggish growth in the US, as the private sector fails to take up the slack from the public sector
3) Continuing sclerosis as the Euro area debt crisis fails to abate
4) Supply chain impacts of the Japanese earthquake
5) Contractionary policy to avoid overheating in emerging economies

But is slow growth really something we should be surprised by?

Although some of the reasons for a downward-revision in expectations (such as the Japanese earthquake) are unique to this recession, high levels of debt and the need for deleveraging are clearly acting as a drag on growth in the US and Europe. But this is to be expected following a debt-induced financial crisis. Especially when extremely high levels of debt reduce creditors' confidence in a sovreign's ability to pay this debt down. 

As today’s Buttonwood blog in the Economist points out, Reinhart and Rogoff’s oft-quoted paper Growth in a Time of Debt makes clear, high levels of public (and private) debt – which are defined as over 85-90% – can have a detrimental impact on the growth rates of an economy. Unfortunately, as Buttonwood notes:

in terms of gross debt to GDP, all the G7 countries bar Germany are already above the 85% threshold, along with Belgium and, of course Greece and Portugal.

Based on this it is entirely rational that countries are looking to deleverage. But – and this is a major but – as this paper by McKinsey points out most episodes of deleveraging are coupled with a period of weaker GDP growth. What is more, in the past, when countries have tried to pay down their debt it has not usually been a multilateral event. This meant that deleveraging countries often saw a boost to GDP growth from net exports even as domestic consumption and investment were subdued.

Buttonwood highlights another paper by Cecchetti, Mohanty and Zampolli, which sums up the problem:

There is a vicious circle to this process since growth is the best way of getting out of a debt trap but the bigger the debts, the harder it is to grow.

As governments and households around the world try to rein in their debt this will inevitably act as a drag on growth. The IMF’s outlook for weak growth in advanced economies does indeed seem to be the most likely outcome.

The Bank of England today published a paper looking at the impact of QE. The paper finds that QE had an economically significant effect, and

“may have raised the level of real GDP by 1½ to 2% and increased inflation by ¾ to 1½ percentage points … equivalent to a 150 to 300 basis point cut in the Bank Rate”

There has already been some debate about these figures, and the authors point out that there are large uncertainties even with the range quoted, but nonetheless they provide a fair amount of ammunition for those who are arguing for more QE.

One of these people is Vince Cable. As he said in his conference speech today:

“A lot of responsibility rests on the Bank of England to relax monetary policy further linked to small business lending”

While there are certainly ways that loose monetary policy does help businesses, it is not entirely clear that policy needs to be any looser than it already is. As far as improving lending to business there are two key reasons why additionally QE may not help:

Firstly, the Bank’s report makes clear that, even with the first round of QE, “the MPC expected little [economic] impact” through the channel of increased bank lending, due to other strains in the financial system. The continued tighter conditions in the financial system are indicated by many factors outside headline rates on lending. Tighter terms and conditions such as stricter covenants in lending agreements and attempts to move companies to more security-heavy forms of lending are discouraging some companies from even approaching their bank to ask for loans.

Secondly, although QE – through reducing the interest rate on gilts – can increase the attractiveness of capital markets to investors, it is not altogether clear that this benefits smaller firms, many of whose owners will be reluctant to use capital market funding which requires them to give up equity.

It will therefore take more than QE to improve the flow of lending to small businesses (discounting, perhaps, some of Adam Posen’s more creative suggestions made last week).

Cable rightly said in today’s speech he wants to see an end to ‘feast and famine’ in bank lending to SMEs. A key step towards this would be an indication of how the government will act in response to the ICB’s recommendations on enhancing competition in the banking sector.

More competition in our banking sector would put downwards pressure on the costs of finance faced by SMEs – critical when we consider other forces simultaneously providing upward pressure.

This is just one example of the more vigorous reform agenda we would like to see the government pursue, as a necessary corollary to a credible fiscal consolidation plan. The government must show it is committed to a relentless programme of dismantling the most important barriers to growth.

Monday morning saw the long-awaited release of the Independent Commission on Banking’s Final Report on reforming the UK banking sector following the financial crisis.

In the lead up to the release we were doing our best to make a lot of noise regarding the Commission’s recommendations on increasing competition in the sector.

This is because we consistently hear from our members that there isn’t any real competition in the UK when it comes to SME banking services.

Too often terms and conditions, rates on loans, service standards, and covenants in lending agreements are nearly identical between the major banks. While accepting some of the forces driving costs for banks will be the same, surely in a competitive market we would expect some variation.

Even more ridiculously we’ve heard stories of a major UK bank refusing to even quote business for a £20 million turnover, profitable company and another major bank deciding it doesn’t want to deal with our defence industry.

Now these may prove to be isolated cases – but even if they are, it’s hardly indicative of banks straining at the leash to provide great service to the real economy.

Our efforts at drawing attention to this culminated in our chief executive, Terry Scuoler, together with the heads of other major business organisations writing an open letter on 10 September urging the government to reform the competitive landscape in UK banking as a matter of urgency.

This is all the more relevant given the government’s increasing alarm at the global economic situation and the impact it may have on the UK’s growth.

Indeed the lobbying leading up to the publication of the ICB report focused a lot on the risks of implementing tough proposals on ringfencing at this moment, given the fragility of the economy.

The concern expressed was that tighter requirements on the banks would further constrain the banks’ ability to lend to businesses.

And the government (and perhaps the Commission) seemed to take these concerns seriously.

So it’s a little surprising in this context that more hasn’t been more made of the need to increase competition as a matter of urgency.

Action here is not about increasing costs for the banks and could provide short-to-medium term support for growth via downward pressure on the cost of accessing external finance.

Predictably perhaps, the press focus has been on the ringfencing side of the Commission’s recommendations. The cost to the banks. The comparison with other countries. Relatively few mentions of competition.

As for the government, so far we’ve had the Chancellor of the Exchequer welcome the recommendations on enhancing competition from the Commission and saying they are in the country’s interest. That’s good.

But as yet there’s no detailed response and no sense that this is a key concern and connected to the struggles SMEs in particular are having accessing the finance the need to grow on reasonable terms.

In a week where the Deputy Prime Minister has stood up and made the government’s concern on the country’s short-term growth prospects plain, it would seem to me that the time is now to be putting the foot down on competition-enhancing reforms in UK banking.

Total manufacturing jobs fell by 11,000 in the second quarter of 2011, driven by a fall in self-employment in the sector. There is some good news underneath this, though, as the number of employee jobs in the sector actually rose, by 6,000. Additionally, while redundancies in the sector edged up, to 19,000, in the last three months, this number remains low by historical standards. As such, although we continue to forecast falls in manufacturing employment, these will be at the slowest rate since 1998, which was the last year in which manufacturing employment grew.

Employment in manufacturing has been falling for several years, but underlying this trend has been a significant improvement of the skills and occupational levels of people in manufacturing. UKCES forecasts suggest that the proportion of people in "higher level" occupations in manufacturing will have risen from 27% in 1997 to 37% in 2017.

Employment by occupation in manufacturing in 1997, 2007, and 2017 (forecast)
Proportion of employees in different occupations

Manufacturing may employ fewer people than it has done in the past, but they are in better, more highly-skilled jobs: exactly the kind of jobs the UK economy needs if it is to continue to compete on a global scale.

Inflation figures released today showed that CPI had crept up a little, to 4.5%, though this was broadly in line with expectations. But this is unlikely to move the monetary policy committee, whose members last month voted unanimously against a rate rise. But the committee’s arch-dove goes further.

Adam Posen thinks things are bad.

And he doesn’t just think they’re bad enough to merit more QE.

“Just because we have [QE] … does not mean we should stop there if the situation is sufficiently serious. Unfortunately, the underlying economic situation in the UK and throughout the G7 is that serious.”

Posen says it is “time for the Bank of England and HM Government to explore ways [to] make up some of the credit and investment gap” that is holding back growth.

What he suggests is:

That the government set up two new public institutions “one would be a public bank or authority for lending to small business” the other would be a Freddie Mac/Fannie Mae style entity to “bundle and securitize loans made to SMEs… to create a more liquid and deep market for illiquid securities which can then be sold off to banks”.

The Bank of England could, Posen suggests, support the creation of these institutions by providing the initial capital.

It’s certainly a bold suggestion or – as FT Alphaville put it – “an intriguing British take on the liquidity trap to say the least”.

The long-awaited final report from the Independent Commission on Banking was released this morning.  The headlines have focused on the timing and costs of the proposed structural reforms.  But it is the lack of competition in the UK banking sector where the real frustration amongst many companies lies. 

In recent weeks we have heard from a company which approached a High Street bank and was told it would not even provide a quote for banking services.  A number of others have advised us that another bank will not do business with their sector.  The SME finance monitor also recently showed that around one in seven companies with a successful application for external finance were seriously considering switching banks, but we know that switching rates are considerably lower than this.  All in all, none of these are the hallmarks of vigorous competition in the banking sector. 

We've been consitently looking for government provide a boost to competition in UK banking.  Our recommendations include:

• Committing to stronger competition in the UK SME bank lending market by following through on the Commission’s call for a greater number of Lloyds’ branches to be sold;
• Looking seriously at impediments for SMEs (larger than micro) switching between banks, including the lack of difference between banks’ offers;
• Improving sources of finance beyond the banking sector for growing SMEs, including equity finance and non-bank debt, for example through extending the Enterprise Investment Scheme to debt;
• Greater transparency and publication by banks of the factors behind certain lending policies and conditions and increased transparency on ancillary costs associated with lending.

So what did the ICB have to say?

There are three main recommendations with respect to improving the competitive landscape.  A strong new challenger in the market as a result of the Lloyds divestiture, improving switching and increasing transparency for consumers. 

On switching, the Commission is recommending that a current account redirection service is established by September 2013 to smooth the process for individuals and SMEs.  The Commission also regards transparency as a 'crucial couterpart' to improving the switching process.  It is recommending that the Financial Conduct Authority and the Office of Fair Trading works with banks to improve transparency in costs and pricing across all retail banking products, including those for small businesses.

The ICB has provided some clear direction on where action needs to focused and this should broadly be welcomed by businesses. 

So what now?      

Well, government had already broadly endorsed the Commission’s interim finding in April that some form of separation was necessary between retail and investment banking.  If there is genuine concern about credit conditions for SMEs and real ambition to make the UK the best place in the world to grow and finance a business then we need to hear much more about implementing the Commission’s recommendations on boosting competition.  As a first step this will require government now to equally endorse the Commission’s proposed reforms to boost competition and set about implementing these recommendations with urgency.

Today’s Producer Price Index release showed that prices facing manufacturers have risen by 16.2% in the last year. A little down from steeper rises seen in previous months, but significant, nonetheless.

The strong rises in commodity prices in the last couple of years has caused significant challenges for manufacturers. Our recent survey for Manufacturing Focus found that 48% of manufacturers saw materials costs were a top-three challenge for their business.

Our Business Trends survey, which we released on Monday, shows just how high and volatile input prices are hitting firms. This quarter’s survey saw a second consecutive worsening in the pressure firms are feeling on margins.

Pressure in margins builds
% balance of change in margins in the last three months

As well as putting up their own prices – when they can – manufacturers are responding to input price rises in a number of ways such as seeking different sourcing options, substituting some inputs and raw materials, collaborating with suppliers, and stockholding materials.

For example, as we reported in Manufacturing Focus, one electronics manufacturer which uses rare earth materials had to respond to the prices of some inputs rising four to six times in the last couple of years. Given the product lifecycle, the company had limited ability to pass price rises on in the short-term so the company chose to stockhold some of its inputs, which has reduced vulnerability to price rises and ensured availability.

However, there is no one-size-fits-all response. For example, other companies we spoke to were unable to bulk buy in one case this was due to unpredictable order flows, and another highlighted risks associated with stockholding such as potential damage to warehoused goods.