DoubleLine: Large Firms Reap Benefits From Central Bank Easing As Small Ones Suffer

By Bill Campbell, co-portfolio manager of the DoubleLine Global Bond Strategy.

Among many of his central bank peers, Bank of England Governor Andrew Bailey has championed the unprecedented balance-sheet expansion by the world’s central banks in their response to the COVID-19 pandemic. In particular, Mr. Bailey argues that the central banks have created the reserves needed to meet the market’s demand for high-quality liquid assets. His argument, however, glosses over an important element for a sustainable long-term recovery.

Reserve expansion has benefited large firms and institutions but left small and medium enterprises (SMEs) behind. This business category comprises micro enterprises (fewer than 10 employees), small enterprises (10 to 49 employees) and medium enterprises (50 to 249 employees). Notwithstanding their relatively small scale, SMEs make an outsized contribution to the economy. In developed economies, the Organisation for Economic Co-operation and Development estimates SMEs on average account for 70% of all jobs and at least half of value creation. Thus, absent reform, the extraordinary measures being pursued by central banks will likely keep unemployment rates higher and productivity levels lower than they otherwise could be.

In fairness to Governor Bailey and his peers around the world, reserve growth is an essential tool of central banking. This tool, however, suffers from some limitations that prevent the flow of vital liquidity into the real economy, erecting obstacles to productivity growth and full employment.

The real question is how the creation of new money, via reserves, is used. Reserves are trapped in the banking system, used as regulatory capital for banking activities such as lending or market-making. Although the intention of reserves is to create more loan and credit growth, and improve overall financial conditions within an economy, practice usually fails to live up to theory. When the liquidity isn’t languishing on bank balance sheets for a rainy day, most of the money flows to large companies. To a large extent, SMEs miss out.

SMEs contribute the majority of jobs and are the driving force of productivity-enhancing investment. According to the U.S. Small Business Administration, small businesses accounted for 44% of U.S. economic activity and created 62% of net new private-sector jobs in the country in 2008-2017. In the U.K., SMEs account for three-fifths of employment in the private sector and 99.9% of the business population, according to the National Federation of Self Employed & Small Businesses. In the EU, SMEs account for 99% of all enterprises and two-thirds of employment, according to Eurostat. In a 2018 paper, “Small Business GDP 1998-2014,” authors Kathryn Kobe and Richard Schwinn found that small businesses produced more GDP for every dollar spent on payroll compared to larger enterprises for 12 of 16 industries. In a 2014 paper, “Making Do with Less: Working Harder During Recessions,” authors Edward Lazear, Kathryn Shaw and Christopher Stanton show that large-business productivity increases in a recession due to increased effort by employees. This contrasts to the innovation that underpins the productivity improvements by small businesses, as pointed out by Kobe and Schwinn.

In order to boost the impact of increased reserves, the domestic banking systems need to offer credit to the more-productive, but often much riskier, sector of micro, small and medium businesses. To be sure, central banks around the globe have pushed forward-targeted lending programs for SMEs. Unfortunately, these programs have been a drop in the bucket compared to the size of the programs implemented by central banks. SMEs have been losing ground for decades. For example, in the U.S., small businesses’ share of GDP fell to 43.5% in 2014 from 48% in 1998, according to the National Small Business Association. During the same period, annual U.S. Nonfarm Productivity growth fell from about 3% to 1%, according to the U.S. Bureau of Labor Statistics.

Lending to these businesses is a tricky issue, given that SMEs are often much riskier credits, necessitating greater due diligence and capital segregation by the banking system. According to the Small Business Association, only 33% of small businesses survive 10 years or longer. On the other hand, startups outnumbered closures in 2011-2015.

According to the U.S. Consumer Financial Protection Bureau, SMEs’ access to traditional sources of credit falls during a recession. In order to boost lending to SMEs, regulations have to be relaxed. This can work without undue risk if underwriting criteria are moderately eased in a countercyclical fashion and if a portion of the new reserves is earmarked for SME lending. Regulatory easing has already taken place, notably with the release of the countercyclical capital buffers in the U.K. and EU. But credit usually finds its way to the larger firms.

Governor Bailey has warned against central banks’ reserves becoming a permanent feature in the commercial banking system, and he has called for detailed examination of weaknesses in the financial system. That examination should also study whom the financial system benefits and whom it does not. With the explosion in debt issuance in the past quarter, many large companies now have cash buffers to survive through several quarters (if not years) of impairments. Their smaller counterparts have not been afforded the same luxury. This dichotomy needs to be addressed as a vibrant small businesses are key to fixing structural issues in an economy such as employment and productivity.