EEF blog

The financial crisis and recession hit the UK hard. The recovery in output for the overall economy has been painfully slow. UK manufacturing has seen a stronger rebound but a lasting scar from the financial crisis is the fractious relationship between the manufacturing and the financial services sectors.

EEF’s quarterly Credit Conditions Survey has consistently recorded a balance of companies reporting an increase in the cost of credit since the onset of the financial crisis, particularly in terms of costs outside of the headline interest rate. The Bank of England has slashed Bank Rate but margins to SMEs have widened considerably i.e. the full benefit of this reduction is not being passed through.

Business-bank acrimony is a discussion topic that doesn’t seem to be going away. This week we had the final release for the Project Merlin agreement where the UK banks made available £215 billion in lending to UK private corporations (excluding other banks) in 2011. However, critics have pointed out the flow of net lending (gross lending extended by the banks less repayments made) to private non-financial corporations actually contracted by £9.6 billion in 2011.

And today the OFT appears set to turn up the heat on the UK banks.

Clearly there are both demand and supply factors at play. Companies are cautious about borrowing because of the economic climate. Many are understandably keen to pay down debt rather than take more on. But supply side factors, including cost and availability of finance, are not helping.

It seems like every second manufacturing SME around the country has a horror story to tell about how the financial sector – and banks in particular – was not supportive when their company needed them most. The result appears to be distrust.

Worryingly this distrust seems to be extending to the point that some SMEs are now choosing to opt out entirely of using external finance to support either their investment or their working capital. The proportion of EEF’s member companies identifying no borrowing needs has steadily drifted up from the low 40s in 2009 to nearer to 50% in 2011q4.

We asked in 2010 how many of our members used only their own retained earnings to fund their expansion; at that time the proportion was 18%. I fear that this has now increased and cannot be positive for growth for the sector or the wider economy.

UK manufacturing needs a strong and supportive financial sector. At a time when the economy is in desperate need of strong business investment growth, the government and the financial sector need to be doing all that they can to relieve credit constraints on businesses looking to grow.

Remember that the government is relying on OBR forecasts of 7.7% growth in business investment this year to drive overall growth. In March 2011 they forecast 6.7% growth in business investment in 2011; that forecast has now been cut to -0.8%. We don't want a similar story in 12 months.

One of the avenues being pushed hard by the government and by the big banks through their Business Finance Taskforce is increasing the supply of alternative sources of finance outside of traditional bank products like overdrafts and term loans.

That’s why at next month’s National Manufacturing Conference there will be a workshop specifically looking at alternative sources of finance. The workshop will be an opportunity to showcase some of those alternative sources of finance that are gaining greater prominence with presentations on asset finance from Lombard, growth capital from the Business Growth Fund, and the suite of government-backed funds managed under Capital for Enterprise.

It will also present an opportunity for delegates to press a panel of experts on how they find out about sources of finance outside of traditional bank lending as well as putting out some challenges as to where the gaps remain. For more information about the workshop and our conference in general visit http://www.manufacturingconference.co.uk/

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”.

A couple of months ago I asked if high effective interest rates were part of the reason that the Base Rate remains so low.

Today the Bank of England released their data on effective interest rates – the actual cost of borrowing money faced by businesses and households.

It shows that the difference between the Base Rate and the rates paid by business and households has increased notably following the recession – the “credit crunch” phenomenon that choked the economy to begin with.

Figure one: effective interest rates are higher since the recession
Average difference between the Bank of England base rate and the actual interest rate paid pre- and post- April 2008.

What is striking is that this difference has not dropped back much since recovery began. This is especially true for secured lending to households, but applies to business lending too. 

Figure two: effective interest rates remain high relative to the Base Rate
Difference between the Bank of England base rate and the interest rate paid by business for outstanding loans

So the low Base Rate is not fully reflected in the interest rate paid by businesses and households. This is the hangover from the credit crunch. And it has implications for monetary policy. For one thing, it implies that – all other things equal – a lower Base Rate could be consistent with lower inflation than was the case pre-recession.

As we laid out in our Economic Prospects report last week, in the face of government cuts, and muted consumer spending, growth in the latter half of 2011 will be reliant on exports and investment.

Today the Bank of England released its agents’ report, which makes a couple of pertinent points about these two drivers of growth.

Firstly, they note that investment intentions are strengthening, even if total investment has slowed a little. Significantly, investment is stronger in those firms where growth is driven by exports. This would suggest that investment growth in this recovery will be closely tied to export growth, especially given expectations that domestic consumption will remain weak.

There is good news, then, as the agents report:

“Manufacturing exports continued to grow at a brisk pace”

Though they did note that:

“for some the rate was slowing slightly”

And this chimes with what we’ve heard from companies lately. On the whole exports are quite strong, even to Europe. In line with what the Bank of England have said, much of this demand is driven by the stronger German and French economies.

It seems, therefore, that the impact of European Sovereign debt crises on UK firms has so far been relatively contained. There hasn’t yet been that “Lehman’s moment” when the debt-crisis trips and becomes a fully-blown Europe-wide (or even world-wide) economic crisis.

But if the crisis does spill over, given our reliance on exports for growth, the risks are real. The fortunes of our major export partners, in particular, Germany and France, are very much tied to those of their fellow Eurozone members. 

Forecasters have become more divided about the prospects for an interest rate rise in May after statistics showed that inflation fell back a little in March, although CPI is still well above target.

It cannot yet be claimed that the inflation problem has been tamed. CPI has been above target for sixteen months now and further energy prices rises are likely to keep it high. But this is not the only problem the UK faces. With large numbers out of work, households are facing a squeeze in both directions. The debilitating combination of sustained high inflation and high unemployment could severely hinder growth in the UK economy.

This risk should not be overstated. The ‘misery index’ – a measure which combines the unemployment and inflation rates – is some way below levels reached in the 70s, the 80s, or even the early 90s. Though it may rise a little over the coming year, forecasts suggest it will fall back as the impact of the VAT rise subsides.

But this is not assured. The worry with inflation is that it – in itself – can cause more inflation. Workers see higher prices, and demand higher wages, this puts up costs for firms who then put up their prices: the so-called price/wage spiral. Avoiding this spiral is one of the reasons credible monetary policy is so important. If people believe that the inflation target will be met, they are unlikely to be too swayed by short-term increases in inflation.

As our pay survey shows, average settlements have not yet been too heavily influenced by inflation. They have risen from the lows seen in the recession, but remain well below the level of CPI inflation. This may not be because people believe in the Bank of England’s inflation-fighting ability, however.

A weaker labour market means weaker pay demands. Unemployment is high, and government cuts mean that more jobs losses are on their way. The weakness of the labour market means that the MPC has so far been right not to raise rates. A lack of consumer confidence had led to muted household spending, which is a major component of growth.

The best policy response over the next few months is not certain. An inflation target that loses its credibility loses its efficacy too. And inflation has remained stubbornly above target. But the MPC’s credibility on its assessment of the broader economy is also important. By raising rates too soon it could choke off the very growth it has so far tried to support. It is little wonder that the MPC have so far held the course.

Last month, the government announced ‘Project Merlin’ its accord with the banks. The most important idea was to get more credit flowing to businesses that needed it. As we said at the time, while we support the intent, we are less than enchanted with what Merlin agreed.

Bank of England data for December 2010 showed that the net change in loans to businesses was negative again. This means that credit in net terms fell back in 10 out of 12 months last year. Interestingly Merlin avoided a net lending target and instead focused on gross lending, perfectly consistent as Vince Cable said in March last year with credit being withdrawn from SMEs who need it.

Today, we have further evidence suggesting access to finance remains a serious issue. Our survey, amongst others covered by the FT, the Guardian, and the Independent, shows that while there has been a modest improvement in the availability of finance this has been outweighed by rising costs. Problems remain most acute for small firms.

The slight improvement in the proportion of companies reporting an increase in the cost of credit in 2010q4 has reversed over the past two months. The balance of companies reporting an increase in the overall cost of credit jumped to 32% from 19%.

In good news, our survey shows that over a quarter of manufacturers expects their demand for external finance to increase in the next twelve months. But this is another source of pressure for 2012 that is already shaping as a crunch year because of the banks’ own refinancing needs. Without an improvement in costs and fees on lending, access to finance threatens to be a drag on investment and growth.

Our survey also shows that conditions are diverging for companies with smaller companies faring noticeably worse than larger companies. Fees on existing borrowing over the last two months illustrates this well:

The proportion of small companies seeing an increase in fees on existing borrowing increased to 32% up from 17% in the previous quarter with none reporting a decrease. By constrast only 6% of large companies reported a rise in the past two months and a similar proportion actually saw a decrease.

There isn’t a big bang solution that we see being able to fix companies’ credit difficulties overnight. However, our survey offers another opportunity to highlight meaningful actions that together and over time will make a difference.

We think it’s important that with its Growth Review, the Budget, and, later in the year, the Independent Commission on Banking’s recommendations, the government doesn’t take its eye off the ball on access to finance. In particular it should consider:

1. Increasing competition in the SME banking sector through ensuring action on any recommendations from the Independent Commission on Banking not only strengthen the banking system but improve possibilities for further entrants into the market;

2. Improving the customer services and perception of banks by enhancing banks’ own customer services commitments through establishing a robust, transparent, and independent system for monitoring their adherence to good lending principles;

3. Encourage development of alternative sources of finance especially non-bank debt and venture capital;

4. Improve knowledge of how to assess risks and returns in real businesses in the financial sector – for example by improving understanding of supply chains and export markets

Today’s announcement of lending targets with the major banks have not gone far enough to address the fundamental issues facing businesses looking to access finance for growth.

While there are some helpful measures, especially Bank of England scrutiny of the targets, we have had lending agreements in the past and they have either been missed (net targets in 2009) or met (gross targets 2010) without material alleviation in the access problems faced by SMEs. Also, as in the past, the targets will prove to be unenforceable.

The announcement also fails to address the flaws that we see as still remaining:

• a lack of competition in the banking sector;
• more alternative sources of finance aside from banks, both debt and equity.
• a need for greater transparency in lending decisions;
• and better real business knowledge in the financial sector.

Competition is important both in terms of the service business customers receive and also lending decisions going forward. Many new companies have had their first big break from a bank looking to enter the market.

Alternative sources of finance have in many cases been choked off by the era of cheap credit leading up to the financial crisis. Private lending, mezzanine debt finance, venture capital, and private equity all need to be boosted to help the economy grow.

Transparency on the lending principles applied and adhered to by banks - and a credible way for monitoring banks sticking to this are important to strengthen the relationships between banks and SME business customers. This is a two way relationship and banks promises to address customer relations in their Taskforce report was welcome. Firms need to respond too by making sure they give their relationship with the bank the attention it needs.

Better knowledge of how businesses, like manufacturing, work should improve both the substance and the perception of how banks, fund managers, and investors decide to inject capital. Again it is encouraging to hear that many banks are looking to build their in-house expertise of the UK manufacturing sector.

2011 is shaping as a crunch year for access to finance. It’s not so much that there’s any bone-shatteringly bad news (in fact that’s mixed with our own recent survey suggesting a mild improvement; other sources less optimistic). Rather the slow progress in resolving issues for particularly small firms accessing the finance they need to grow risks being a major hangover in 2012.

That’s a big reason why access to finance is one of the forces we are watching in 2011 and is given some attention in a report we’re releasing on Monday Economic Prospects 2011.

In 2012 several new forces will run against the freeing up of the flow of finance. The Telegraph today highlighted how banks are already adjusting their behaviour in anticipation of new regulatory requirements under Basel III, coming into force from 2012. This is the need for banks to hold a higher level of core capital against the loans they put out, an important part of stabilising the system against financial shocks.

According the Bank of England, banks are also already reporting tough conditions refinancing themselves on wholesale funding markets. Difficulties they have in accessing funds, or the higher prices they may have to pay, will flow through into what they in turn charge for loans they issue. 2012 is again key because a large volume of banks’ funding is due to be refinanced in that year.

And of course, 2012, all going well, firms will be increasing their investments and so demand for finance will be higher. It would be a cruel blow to growth if this investment were stifled by problems accessing finance.

So that points to the importance of 2011 in taking those actions that can make a difference to help offset the challenges of 2012.

The banks and government have already made some commitments late last year. But these aren’t enough. We need to see further and faster progress on increasing competition in the finance sector – both within and outside banks. Debt finance is especially important to small firm owners who don’t want to lose equity stakes in businesses they’ve worked hard to grow.

Viable proposals are still being knocked back following the financial crisis because banks’ appetite for risk has fallen and the high-leverage, high return years of debt finance have choked off options outside banks. We need a renewed appreciation of the importance of banks’ relationships with their customers – an injection of real business understanding would help. Let’s see banks building their expertise on industries and firms themselves rather than relying solely on conservative lending formulae.

On the demand side too, smaller businesses need a stronger understanding of and willingness to consider alternative finance options. And where firms may require help in understanding and assessing these options cost-effectively there may be a role for government.

The government’s first opportunity to show some resolve is at the Budget in March; 2011 needs some action to get ahead of the curve.