New research looks at the potential longer-term impact on jobs and productivity of government guarantees for emergency loan support to small and medium-sized enterprises (SMEs) during the pandemic. The study by Charles Goodhart, Dimitrios Tsomocos and Xuan Wang warns of the potential misallocation of resources from keeping alive enterprises that are sub-par, even zombie companies.
Assuming that the government puts some eight on allocative efficiency, in order to raise productivity and output over future years, it will need to try to screen out unprofitable and less profitable potential borrowers. The analysis explores the degree of screening that would be socially optimal in terms of protecting jobs now while avoiding damage to the economy’s future prospects.
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The combination of the pandemic and the policy measures of lockdown in response has had a drastic effect on the cash flows and solvency of small and medium-sized enterprises (SMEs) worldwide. If a country was to avert an economic collapse, with a large proportion of its SME population being forced to shut up shop, the need was to get external financial assistance to them quickly.
Many countries in Europe, as well as the United States, implemented credit guarantees for their loan support to SMEs. For example, in the UK, the government then decided that such emergency loans to SMEs, known as ‘Bounce Back Loans’, (BBLs), would henceforth be 100% guaranteed by the government, that is, they would not count as non-performing loans or cause losses to the banks.
Similarly, in Germany, the credit guarantee covers from 90% to 100%, and in the United States, the government credit guarantee ranges from 95% to 100%. But the Netherlands and Spain seem more prudent, and the credit guarantee in the Netherlands can be as limited as 67.5% (see ECB Financial Stability Review, May 2020 and ECB Economic Bulletin, Issue 6 2020).
The government credit guarantees have triggered a series of public comments on the likely massive defaults on emergency loans once the pandemic is over. See, for example, Stephen Morris et al (2020), ‘UK banks warn 40%-50% of ‘bounce back’ borrowers will default’, Financial Times, May 31; Jill Treanor (2020), ‘RBS boss Sir Howard Davies calls for toxic coronavirus loans fund-Chairman warns of mass defaults by stricken small firms' Sunday Times, May 3; Douglas Elliott (2020), ‘Top 5 Concerns about Policy in the New Era', Oliver Wyman, April.
One major concern is the likely misallocation of resources from keeping alive enterprises that are sub-par, even zombie companies. Assuming that the government puts some weight on allocative efficiency, in order to raise productivity and output over future years, it will need to try to screen out unprofitable and less profitable potential borrowers.
Recall that in some countries such as the UK, the government has withdrawn this role from banks in pursuit of a swifter disbursement of funds via 100% guarantees. Countries such as the Netherlands and Spain seem to have taken a stricter stance. So, should the government take a lenient or harsh stance?
This study aims to assess the normative issue of whether and what degree of screening would have been socially optimal given different features of the underlying economy. To this end, the authors develop a model whereby the government uses a default sanction as a screening device. The default sanction can be interpreted as requiring a certain level of personal guarantee by the borrowers.
The model shows that if the government is pro-allocation, that is, caring more about future productivity, it can choose a harsh default sanction to deter unprofitable potential entrepreneurs from applying for loans, but this pro-allocation policy leads to unemployment in the short run, and demand shortage is persistent.
If the government is pro-stabilisation, that is, caring more about short-term employment stabilisation, the model shows that the government can choose a lenient default sanction or even no sanctions (100% guarantees) to restore short-run employment once the pandemic has passed. In this case, demand shortage is short-lived, but the economy is shifted to a lower long-run equilibrium due to misallocation. The optimal screening lies somewhere in between these two extreme scenarios.
Moreover, the model finds the better the lender’s monitoring scheme works well, or the less competitive the industry is, or the lower the profitability of the applicants, then the government is more likely to take a harsher stance, although a long-run scarring effect pushes the optimal default sanction to a more lenient stance.
Furthermore, the model shows that at the interest rate lower bound, a harsh default sanction causes an aggregate demand externality, so the optimal default sanction becomes more lenient, and the government is likely to offer more generous credit guarantees. This is pertinent now since the interest rate of major advanced economies is at the historically low level.
Goodhart, C., Tsomocos, D.P. and Wang, X., 2020. Support for small businesses amid COVID-19. CEPR Discussion Paper Series. Tinbergen Institute Discussion Paper TI 2020-044/IV.
