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hen examining the issue of debt, we often take a macroeconomic perspective to the problem, looking at measurements such as the debt to GDP ratio (the amount of intesrest a country needs to pay for loans). While looking at the macroeconomics perspective gives important clues on an economy-wide basis, failing to understand the problem from a microeconomics perspectives (from the individual firm level) will compromise our understanding of the problem. That is what this article hopes to cover—the lesser known aspects of debt, loans, and borrowing at firm level compared across industries. As we look to understand the act of taking on loans by firms, we cannot ignore the centerpiece in all these activities—the banks that accept deposits and dish out loans. It was in the not-so-distant past (2008) that we saw
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big banks in developed countries facing a crisis never felt before. Was it related to the loans given out by those banks to firms? Let’s see! Firms are producers that undertake the risk and effort to organize different types of factors of production in different combinations to offer goods and services in return for profits. Different firms take on different levels of risk as they foray into different types of industries. Some industries will require more financial capital while other less, so the corresponding level of risk will differ. How are firms spreading these risks? What are the mechanisms available for firms to leverage what they have and increase the risks?
COSTS IMPLICIT AND EXPLICIT
Land, labour, and capital are the essential factors of production deployed by a producer to produce different types
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of output. Land refers to resources provided by Mother Nature itself— unspoiled minerals. Capital refers to manmade resources, such as machinery that aids in the production of goods and services. Labour works with the resources of land and capital to generate output based on the direction of the enterprise. In the process of acquiring land, labour, and capital, financial ability to purchase these factors of production will be required. But where does the financial capital for all these come from? In setting up a firm, upfront costs cannot be avoided and the financial capital can be from a producer’s own savings, in which using it entails an implicit cost to be added to the cost of production. An entrepreneur using $100,000 of his own savings to finance the acquisition of the various factors of production will miss the chance of putting that $100,000 in a bank to earn interest. The interest earnings forgone
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microdebt KEY POINTS OF QUERY Why do firms seek loans? Do firms in certain industries tend to borrow more? Do large firms or small firms require more borrowing? What happens when firms take on too much debt?
are then implicit costs to the firm to be added to the total costs of production. Otherwise, a firm will need to borrow its startup financial capital from a bank. The interest charged for borrowing money will become an explicit cost to the firm. In the real world, other avenues of raising the financial capital include getting investors to plough in money, known as venture capital or seed funding. This applies to small and medium sized firms as raising financial through more complex means such as selling shares of the company through listing on stock exchanges is not an easy option. Besides needing to raise financial THE DEBT ISSUE
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SKILLS capital when first establishing a business, loans are also required for various needs, such as maintaining inventory, expansion of business, purchase of new machinery, research and development programs, or marketing projects.
TENDENCY TO BORROW BY INDUSTRY
When understanding the nature of business loans, we need to realize that firms have varying natures. The tendency to borrow varies widely across the industry in which a firm does business as well as the size of the firm. Does a large firm require more loans or does a small firm require more? Looking first at the industry’s nature and the need for loans, we would expect the need for loans to rise with the capital intensity of the firm. A firm requiring a huge amount to build facilities and to purchase machinery would require a bigger amount of financial capital and a need for loans, since the ability to have that initial pool of a few million dollars would be rare. Industries such as construction and capital intensive manufacturing require large amounts of loans for the purchase of specialized construction equipment. Transport companies such as shipping and airline companies would also need loans to purchase costly ships and aircraft. With this understanding, let us look at Figure 1 to see if this concurs with what
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has been explained. Even though, from Figure 1, certain industries see a greater need for loans due to the need for expensive machinery and technology (such as building and construction), the amount of loans shown in Figure 1 is not simply a function of a firm’s demand for loans, but also an outcome of supply of loans. The supply of loans given to any particular sector can be controlled through government intervention. Governments can encourage the disbursement of loans to priority sectors or curb loans to non-productive areas, such as when companies borrow money to channel into real estate speculation. The Chinese government, at the start of 2010, had to set curbs on banks giving out loans to sectors already having overcapacity. Due to a stimulus package
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Firms driven by an optimistic outlook may overestimate the returns from investment and since the cost of borrowing was low – this made projections on investment projects even more profitable.
factories were overzealous with their expansion plans, taking on loans to further expand capacity even though there was idle capacity. When supply capacity increases without corresponding increases in demand, greater problems await. Loans in China had to be redirected towards the automobile industry, where capacity was running at nearly full levels.
EVEN THOUGH, FROM FIGURE 1, CERTAIN INDUSTRIES SEE A GREATER NEED FOR LOANS DUE TO THE NEED FOR EXPENSIVE MACHINERY AND TECHNOLOGY (SUCH AS BUILDING AND CONSTRUCTION), THE AMOUNT OF LOANS SHOWN IN FIGURE 1 IS NOT SIMPLY A FUNCTION OF A FIRM’S DEMAND FOR LOANS, BUT ALSO AN OUTCOME OF SUPPLY OF LOANS.
FIGURE 1 BANK LOANS AND ADVANCES TO NON-BANK CUSTOMERS BY INDUSTRY (AT END OF PERIOD)
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Source: Monetary Authority of Singapore
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Governments also often set directives on loans to be given out to priority sectors that are identified as key industries for growth, such as green industries. Where loans get disbursed is also determined by where banks are willing to make loans. Banks with an aim of increasing the returns from money lent out will extend loans to sectors where the risk of default is low and to growth sectors where corresponding demand for loans will be high.
OVERZEALOUSNESS WRONG DECISIONS
It’s generally a good thing when loans are channeled to productive uses, such as the building of new plants and discovering new technology, compared to non-productive loans for purchase of real estate in a bid to cash in on rising housing prices. However, trends that appear to be good on the surface can in fact be detrimental to the economy. Too many loans taken by firms in an overzealousness of increasing plant sizes can be a time bomb waiting to explode and have detrimental effects on the wider economy.
When firms are already sitting with idle capacity, with factories running at half the optimal capacity, firms can easily meet any sudden rise in demand by upping production levels without facing any constraints. The supply of its goods will still be fairly price elastic. Why then do firms still look to expand in the face of idle capacity? Sometimes it boils down to over-optimistic outlook of the economy. Expecting demand for a product to rise dramatically, firms invest in multi–million dollar plants, yet demand can never ever rise to those levels. Sometimes it’s driven by the need to lower long-term production costs. Firms may want to upgrade production techniques and invest in a new facility. The deal with production facilities is also that there are minimum levels that make sense. It’s basically economies of scale, whereby the cost difference of building a smaller and relatively larger plant size is not too large. Firms can easily get Banks, in minimizing their losses, will take any capital goods or inventories to sell off and recover whatever value of loan outstanding from these assets.
swayed into opting for bigger plants. This is especially true when the cost of borrowing is low and the cost difference of interest repayments to the bank of a larger loan is not significantly larger for a bigger plant. With so many factors favoring a larger plant and in the heat of keeping up with competitors, firms want to take on expansion despite current underutilization of resources. If projections go through and demand rises, the firm with the foresight to take on expansion will have the final laugh. Yet if the projections fail, firms face the cost of miscalculation, a high cost of servicing loans and a low level of output will raise the per unit fixed costs of production. The larger than needed manufacturing plants also need servicing and maintenance, which adds to the firm’s operational costs. If the firm’s revenue cannot cover its cost of production and its loan repayments, it finds itself indebted and banks seeing this situation may force the firm to shut down, as the banks want to reduce risk and get back as much of the loan as early as possible. THE DEBT ISSUE
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SKILLS A firm can always try to get rid of its expanded plant, but bear in mind that there are also high costs of exit. Firms need to sell off and may engage professional help in finding the right buyer, which involves cost as well. If the problem of overzealousness is confined to only a few firms, the negative impact can be restricted to individual firms. The problem is that such overzealousness often takes place within firms of an industry as intense competition drives the need to keep ahead and overrates the benefits of expansion. If firms within an industry all take on extra capacity, the industry will be plagued by the problem of high debt and high default if the expected industry boom does not materialize. The industry will then see a sudden increase in supply, The increase in capacity and sudden increase in output produced will cause a slump in prices. Given the sudden increase in industry output, prices will plummet, causing revenues to fall tremendously.
with demand failing to keep up, leading to excess supply and prices going into freefall, driving down profits and forcing firms to exit in the long run. Firms taking on excessive loans are the start of a brewing of the boom-and-bust cycle seen in many industries, such as cotton, e-commerce, and steel.
TENDENCY TO BORROW BY FIRM SIZE
Besides the type of industries and their need for loans, another way to look at
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BANKS FAVOR LENDING TO BIGGER FIRMS SINCE THEY ARE PERCEIVED TO BE FINANCIALLY SOUNDER AND THE RISK OF LARGE FIRMS DEFAULTING ON THEIR LOANS WILL BE LOW. the nature of firms and loans is the size of firms. Which types of firms have a greater tendency to borrow? Large firms or small firms? Banks favor lending to bigger firms since they are perceived to be financially sounder and the risk of large firms defaulting on their loans will be low. Whereas medium and smaller firms are not as established and can easily run into negative profits when new competitors arise, lending to such firms is considered riskier. In fact, larger firms are perceived as better clients that enjoy lower cost of borrowing as the amounts of loans are larger, the profits to banks from a big loan are higher. This tendency for loans to be given to large firms has led to medium and small firms experiencing difficulty getting loans when they in fact have a greater need for them. Why? With less surplus profits from years of operation, these firms have less to fall back on or lack the financial capital needed to undertake expansion or the marketing needed for them to stay ahead. So smaller firms, though having a greater need for loans, have less access to loans.
This lack of loans is addressed by governments seeking to give aid to smaller firms to encourage more entrepreneurship and to increase the level of competition in the domestic economy by making loans accessible to smaller firms and keeping them alive. Programs offering “soft loans� offer preferential or even interest-free loans for specified purposes, up to a given limit. In Canada, for instance, firms with annual revenues of less than $5m qualify for such loans. A government policy to render assistance to small firms becomes even more important during a recession. As seen in Figure 2, the amount of loans given out by banks falls in a post-recession period. In the shaded bars, indicating times of recession in the US, the dollar value of loans fell correspondingly. Supply of loans evaporates in a recession as income levels fall and absolute savings amounts fall, even though the marginal propensity to save increases. Likewise, shrinking profits means firms have less surplus to offer up as supply of loans. On top of that, demand for loans increases during a recession as firms with negative profits depend on loans to stay afloat. Profitable businesses may face cash flow problems, as expenses are to be paid out first and it takes longer to collect revenues owed to them. Again, this problem is especially acute for smaller firms with little to fall back on. Governments come to the aid of small firms by extending loans, as in almost every country the SMEs make up the bulk of employment in a country.
FALSE SECURITY SINGLED OUT INDUSTRY
These days, we have seen recessions bring down not only small companies, but also big firms, from big global banks to giant airlines.
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Certain industries have been so mammoth in their need for loans and industry performance in terms of profitability has dipped so much that meager banks are unable to offer the type of financial assistance that such firms in the industry needs that they have received loans directly from governments. Collectively as an industry, each firm in the industry has been unable to keep afloat as every firm has been riddled with negative profits, quarter after quarter. Such was the case for the US automobile industry as US$25 billion worth of loans to the auto industry was seen as a much-needed lifeline from the government. More recently, the airline industries across the world, regardless of nationality, have also sunk into deep trouble as profits dived and remained
negative. From Air India to British Airways, the industry has performed terribly and has put out calls for government bailout or aid. Besides being singled out for special assistance from the government, industries have also been given special access to loans as these industries have been identified as growth industries. In 2011, China introduced policies to curb loans given out for the purchase of houses and to prevent excessive liquidity in the system. To ensure that such a policy would not hurt the need for loans in productive areas such as in the growth of firms, the Industrial and Commercial Bank of China announced that it would double the amount of loans given to China’s key strategic industries, such as high end manufacturing, the service industry, and the green sector (Xiang, 2011).
FIGURE 2 BUSINESS CYCLE AND SUPPLY OF LOANS
RISK APPETITE
When it comes to the motive for firms to take on loans, the nature of an industry and the nature of a business in terms of cash flow play a role in helping us understand the tendency to take on those loans. Yet there is also the inexplicable aspect of the risk appetite of firms, ruled by what Keynes termed the “animal spirit”. Some firms have an aversion towards taking on more loans. Prudent firms fear borrowing and can be hesitant about expansion plans. Conversely, firms that are overzealous take on too much and end up riddled with debt. Banks thus have an crucial role in giving out loans to the “right businesses”. It’s a task that is not simple, since banks give out loans with imperfect information, such as whether the management of the firm is making the right decisions, cutting costs, etc. Despite being an uphill task of issuing loans to the right firms, giving out loans is an important lubricant to a healthy, growing economy. It is not good for an economy to have excessive idle funds lying around instead of being allocated to firms that are in need of such funds. BIBLIOGRAPHY Qiaoyi, L. (2010, January 06). Global Times . Retrieved July 10, 2012 , from Global Times : http://www.globaltimes.cn/business/chinaeconomy/2010-01/496498.html Xiang, L. (2011, March 7). China Daily. Retrieved July 9, 2012, from China Daily: http://www.chinadaily.com.cn/ china/2011npc/2011-03/07/content_12125848. htm
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