Michael C Bonello: Financing the small business sector - constraints
and opportunities
Speech by Mr Michael C Bonello, Governor of the Central Bank of Malta, at the European
Federation of Ethical and Alternative Banks and Financiers Seminar, St.Julian's, 15 April
2010.
* * *
The holding of a seminar on credit for small businesses is both appropriate and timely given
the important role played by these enterprises in modern, free-market economies and the
contribution they are likely to make in the recovery phase as economies emerge from
recession. It is perhaps not widely known that of the almost 20 million enterprises active
within the European Union (EU) in 2005, 99.8% were small and medium-sized enterprises
(SMEs), defined as businesses that employ fewer than 250 persons.1 In turn, more than
nine-tenths of these were micro enterprises, with a workforce of fewer than 10. In 2005
SMEs accounted for 58% of the value added generated in the EU and 67% of all
employment, compared to 55% in the US.2
Small businesses are a major source of dynamism in the Maltese economy too. SMEs
constitute the overwhelming majority of businesses, accounting for over 99% of the total and
two-thirds of total employment. The vast majority are micro enterprises. These small
operations act as customers of, and suppliers to, larger companies and are an essential
source of entrepreneurship and innovation. It is thus no exaggeration to say that small IMF
Update of World Economic Outlook, January 2010.businesses form the backbone of
European economies, including Malta's.
A better understanding by policymakers of this sector and of the constraints it faces, which
are often different from those encountered by larger firms, is therefore crucial for the purpose
of further expanding the economy's growth potential. In the current environment
characterised by a reduced availability of credit and tighter lending standards, the financing
needs of small businesses deserve particular attention. In this regard it is important to recall
that SMEs in general, and micro enterprises in particular, are more dependent on the
banking sector than larger firms, which have the expertise and the resources to tap the
capital market. This is very much the case in the euro area: between 2004 and 2008, banks
accounted for roughly 70% of the total external financing requirements compared to just 20%
in the US.
This critical role of bank credit partly explains the unprecedented liquidity-providing
operations undertaken by the European Central Bank since August 2007 designed to sustain
the flow of credit to the real economy during the crisis, and the repeated calls by the
Governing Council for banks to reinforce their balance sheets so as to be better able to fulfil
their responsibility in this regard.
The economic environment in the near term
The world economy is finally emerging from the most severe recession in recent history.
Global output declined by 0.8% in 2009, while trade volumes shrank by more than 12%.3
Economic activity in both the euro area and the United Kingdom, Malta's largest trading
partners, declined by 4.1% and 4.9%, respectively. This contraction had inevitable
consequences for labour markets, with unemployment increasing to levels not seen in
decades. The combination of lower tax revenues and higher outlays arising from the
operation of automatic stabilizers and fiscal stimulus programmes took their toll on public
finances, with deficits in a number of countries rising close to, or even exceeding, double
digit levels. The growth rate of these economies over the coming years will be constrained by
the inevitable fiscal consolidation required to bring deficit and debt ratios back to sustainable
levels.
These recessionary headwinds inevitably took their toll on Malta's open economy. The
impact, however, proved less severe than might have been expected. The economy came
out of the recession in the fourth quarter of 2009, after contracting for three consecutive
quarters. On a seasonally adjusted basis, the peak-to-trough drop in GDP was around 3.0%,
compared to 4.7% in the euro area.
The relative resilience of the Maltese economy is attributable to four factors. First,
membership of the euro area has enhanced its capacity to withstand external shocks.
Second, the impact of the financial crisis was mitigated by the strength of the domestic
banking system, underscored by the absence of toxic assets in bank balance sheets, prudent
lending policies and a funding structure based primarily on retail deposits. The third factor
was the strategy of temporary government assistance targeted to those non-financial
corporations (NFCs) that were in difficulty, mostly in the manufacturing and tourism sectors,
along with the implementation of some infrastructure projects. Besides limiting the number of
potential job losses, this approach proved to be more appropriate in the domestic context
than an across-the-board increase in spending whose impact would have been severely
weakened through import leakages. The fourth factor was the continuing diversification of the
economy towards high value-added services, which have proved less vulnerable to the
downturn. Small businesses have featured prominently in this process. Indeed, most of the
enterprises in the emerging sectors of the economy, such as those in pharmaceuticals,
remote gaming, ICT and business and financial advisory services are SMEs.
Going forward, the prospects are for only slow growth in Malta's external demand. While IMF
projections suggest that global activity and trade volumes will expand by around 4% and 6%
this year, respectively, the recovery in the euro area promises to be less robust and more
gradual than in other advanced economies, and is expected to be conditioned, inter alia, by
the ongoing process of balance sheet adjustment in both the private and the public sectors.
Economic activity is therefore expected to remain sluggish and uneven in 2010, with GDP
expanding by less than 1.0% in both the euro area and the United Kingdom.4
Mirroring these expected trends abroad, the Central Bank of Malta's projections point to a
modest GDP growth rate of around 1.0% in 2010. Net exports are likely to contribute
negatively to growth, so that the main growth impulse is expected to come from domestic
demand, driven by higher investment outlays on infrastructure projects and, to a lesser
extent, by a moderate expansion in private consumption. Labour market conditions are
unlikely to improve this year, with the unemployment rate remaining above 7%. This subdued
growth outlook, together with the expectation that inflation will remain more elevated than in
the euro area, will exert downward pressure on disposable income.
Overall, therefore, the economic environment facing small businesses in the foreseeable
future, both domestically and in our main trading partners, will be less favourable than that
which prevailed before the onset of the financial crisis in 2007.
Small businesses access to finance
Since SMEs and micro enterprises are typically more dependent on bank financing than
larger firms, the ongoing deleveraging of bank balance sheets in many EU countries
represents a potential threat. The prospect of a prolonged period of restricted access to both
working and investment capital at a time of subdued demand could result in the closure of
many enterprises.
In the euro area, credit growth has indeed slowed progressively during the past year. The
latest figures, for February, suggest that loans to the private sector contracted by 0.4% from
a year earlier. The annual growth rate of loans to all NFCs - large, medium and small - fell
from a peak of almost 15% in April 2008 to -2.5% in February.
With regard to credit flows to SMEs, a recently published ECB survey, which however does
not include the five smallest countries in the euro area, including Malta, shows that SMEs
were generally less successful than large companies in obtaining bank loans in 2009, even if
the majority received part or all of what they had applied for. In the second half of 2009, 75%
of all SMEs reported successful approaches, slightly less than in the first half of the year. The
main reasons given by the banks were the general economic and the firm-specific outlook,
together with a reduced willingness to extend credit.
It would appear, therefore, that both demand and supply factors explain recent credit
developments in the euro area. This conclusion is corroborated by the evidence from the
Bank Lending Survey, which points to factors associated with the weak macroeconomic
conditions, such as a lower demand for credit due to less fixed investment, combined with
supply side factors such as the tightening of credit standards.
The restricted flow of credit in the euro area does not, however, appear to have been
replicated in Malta, whose banking sector emerged from the financial turmoil with high capital
and liquidity ratios. Domestic credit to the private sector continued to expand at steady,
though slower, rates in 2009. The annual rate of increase in bank loans to the private sector
declined from around 10% in 2008 to 8.3% last year, and the latest figures for February
suggest that total credit is still expanding by over 6%. Lending to NFCs, meanwhile, is
growing at an annual rate of 3.9%.
With regard to the recent experience of domestic small enterprises, our estimates suggest
that bank lending to them expanded by around 6.6% per annum between 2005 and 2009.
This impression of a sustained credit flow is confirmed by a joint survey carried out by the
European Commission (EC) and the ECB during 2009.5 The results for Malta are based on a
sample of 100 enterprises, of which 94% were categorized as micro enterprises in the
services sector with an average annual turnover of less than EUR 2 million in 2008.
One of the most significant results was that small enterprises in Malta did not consider
access to finance a main concern. Only 8% of respondents cited it as their most pressing
problem, compared to 16% in the EU. In addition, only 12% thought that the willingness of
banks to provide a loan had deteriorated, while the number of those replying that banks were
actually more willing to extend credit was among the highest in the EU.
At the same time, however, the demand for bank loans by domestic small enterprises last
year was weak. Only 10% of respondents applied for bank loans compared to 22% in the
EU. The indication of a subdued demand for loans is confirmed by information derived from
the Bank Lending Survey and from other intelligence collected by the Central Bank of Malta.
One possible explanation could be the fact that small businesses in Malta rely on a mix of
internal and external finance to a greater extent than their European counterparts. Another is
the reported postponement of investment plans in the light of the slowdown in both domestic
and external demand.
Albeit to a lesser extent, supply side factors also seem to have been present. For example,
according to the joint EC/ECB survey more than half of the small businesses in Malta
considered the interest rate as the most limiting factor for obtaining a bank loan, a higher
proportion than in any other country surveyed. And about one fifth reported that they had
actually refused the loan offered because they considered the interest rate as too high.
Again, this was by far a higher percentage than anywhere else in the EU, where on average
only around 6% cited high costs as a reason for turning down a loan. In the same vein, the
proportion of Maltese businesses replying that interest rates charged on loans had
decreased was among the lowest.
These results support the information obtained from an analysis of bank interest rates. In
general, while domestic banks have reduced interest rates charged on loans to households
by more than the average in the euro area following the cumulative cut of 325 basis points in
official rates by the ECB since 2008, the opposite is true for loans to NFCs. This suggests
that domestic NFCs, most of which are small enterprises, are finding it more expensive to
obtain or service a loan than their counterparts in the euro area. This apparent relative
rigidity of domestic interest rates charged to NFCs merits further analysis as it could harm
the recovery process, particularly if businesses continue to postpone their investment plans.
Other constraints faced by small enterprises in Malta
The same survey also provides an insight into the broader range of concerns faced by
domestic micro and small enterprises. These include the limited purchasing power of
customers, obstacles faced in trying to expand market share and competitive pressures. In
addition, a disproportionately high percentage of these businesses reported higher costs in
2009.
In this regard, the automatic adjustment of wages to inflation through the COLA mechanism,
irrespective of the level of productivity, is one of the factors that has been contributing
adversely to the cost structure of these enterprises, and consequently to their competitive
position. Here I must reiterate that a currency union member country like Malta, whose only
sustainable source of long-term growth are its exports, cannot afford to allow nominal wages
to grow faster than productivity, which is what has happened during the past decade.
The competitive position of these enterprises is also constrained by their ability to introduce
more efficient production processes. The proportion of enterprises that did not undertake
some form of restructuring last year was one of the highest in Europe. This is probably one
reason why Malta has lagged behind its European peers in pursuing the targets set by the
Lisbon Innovation Scoreboard, in particular in the areas of entrepreneurship and human
resources.6
Another frequently mentioned cost factor are administrative burdens. This is an endemic
problem in Malta, confirmed by a recent survey in which a reduction in such burdens featured
as the priority recommendation by executives of foreign-owned companies operating in Malta
as a means of enhancing the attractiveness of the island to foreign investors.7
Finally, with regard to the constraint represented by the small size of the domestic market,
Maltese entrepreneurs have no option other than to attempt to break into foreign markets.
This is not an easy task. During the past decade, Malta has registered one of the slowest
average annual export growth rates in volume terms in the EU. Survey information from
micro and small enterprises reveals that the most frequently cited obstacles to exporting
relate to taxation issues in foreign markets, inadequate market intelligence and insufficient
capital.8
Recent initiatives and the way forward
This suggests the need for a comprehensive strategy to help these small enterprises exploit
the opportunities offered by the EU Single Market, building on the existing public and private
initiatives. The Budget for 2010, for example, included measures aimed specifically at easing
some of the constraints I have just referred to. Chief among these is a 40% tax credit
scheme, which is directed at micro enterprises that invest in productive processes or create
more jobs.
Meanwhile Malta Enterprise is playing an active role in assisting small businesses to tap
EU regional funds. It has been recently reported that applications for grants from the
European Regional Development Fund (ERDF), from which EUR 20 million for industry and
EUR 10 million for investment in renewable energy are available, have led to the selection of
almost 400 projects with a proposed outlay of EUR 25 million. An additional EUR 7 million,
announced in the Budget for 2010, is also being made available. Maltese entrepreneurs have
submitted more than 600 proposals for funding under the third call of the ERDF scheme, with
the total value of assistance requested expected to exceed EUR 40 million.
At the same time, an agreement between the Government and the European Investment
Fund will provide another EUR 10 million by the end of this year from a specialized EU fund
aimed at small enterprises that would otherwise find it difficult to raise up to EUR 25,000 to
improve their operations. These initiatives should also help to increase awareness about
EU funding schemes.
Malta Enterprise is also involved in the management of the Kordin Business Incubation
Centre. Between 2003 and 2008, this facility produced over 50 start-ups, with a success rate
of 86%. Some of the most successful ventures have gone on to employ more than
100 workers. Within the next few months small enterprises will also benefit from more than
300 industrial spaces that will be made available in three locations, while other parks for
micro enterprises in both Malta and Gozo are in the pipeline. Such initiatives facilitate
networking among SMEs and can lead to the development of business clusters and
consequent positive spillover effects.
Initiatives to assist small businesses have also been taken by the private sector. For
instance, a major domestic bank has recently teamed up with a leading international software
house in a programme designed to increase the success rate of ICT start-up companies. A
number of banks have established dedicated funds or have tailored business packages that
are specifically designed to meet the demands of small enterprises. In contrast, however, the
concept of investing private money in small enterprises has yet to gain currency in Malta, and
the commitment of government funds for the establishment of the first official venture capital
fund has so far not been followed up by private investors.
Conclusion
Small businesses have undoubtedly contributed to the resilience shown by the Maltese
economy during the recession. Indeed, the majority of emerging niche industries in both the
manufacturing and the services sector belong to this category. Going forward, they could
also play an important role in sustaining the recovery. This calls for the creation of a more
congenial environment, which not only allows entrepreneurship to flourish but also focuses
on the ingredients that will become increasingly important in the post-crisis economic
environment. These include a greater emphasis on innovation, research and development
and marketing, drawing on EU and public and private financial assistance schemes. Without
such a proactive orientation, small businesses cannot hope to overcome the limitations
inherent in a small domestic market.