Blogging about

Money Programme

Get the facts behind the big business and finance stories from around the world – and down your street, in The Money Programme.

The adage that ‘cash is king’ in business appears to be even more powerful and relevant in the recession. The rapidity and unanticipated consequences of the credit crunch as it developed into a full blown financial and economic crisis created seismic shocks in sectors and firms in the economy.

In 2009, real Gross Domestic Product is forecast to contract by 0.5% in the global economy; 2.8% in the US; 6.2% in Japan; 3.5% in the EU; 6.1% in Germany and 4.8% in the UK. The rise in manufacturing output in the UK of 0.4% between March and April, notwithstanding, the drying up of liquidity in the banking system is still having profound effects on the ability of firms to survive and thus avoiding significant unemployment. At the heart of this survival is maintaining cash flow at whose court all enterprises must bow.

SMEs are squeezed between a rock and a hard place.

Avoiding bankruptcy has become challenging, as firms chase customers and side-step suppliers demands in order to maintain cash flow. For firms that trade globally, cutting off or suddenly limiting access to lines of credit, as orders have dried up, probably sounds their death knell. For example, in the first three months of 2009, global trading in stainless steel industrial products (sheeting coils etc) fell by 40%, due in a large part to the cutting off of lines of credit. Small and medium-sized enterprises (SMEs), particularly in manufacturing supply chains, are squeezed between a rock and a hard place. In order to cut costs, they reduce number of employees but frequently cannot afford to pay redundancy entitlements, leaving bankruptcy as the only viable alternative.

Unemployment is cited as a lagging indicator in the economy, in that it tends to follow on from a downturn. This is still true as unemployment is set to rise in the UK from its current total of around 1.7m to about 3m in 2010 (roughly just over 9% of the workforce on the International Labour Organisation measure). In this recession, unemployment has also been a leading indicator, in that rising unemployment totals in the US, and then Europe, were starting to become apparent at the onset of the credit crunch and financial crisis. This was pointed out by the outgoing external member of the Bank of England’s Monetary Policy Committee (MPC), Professor Danny Blanchflower of Dartmouth College in the US. If his and other warning voices had been heeded, then interest rates would have cut more sharply and some of the worst of aspects of the recession avoided, with the obvious consequences for SMEs under stress.

There are, however, more long term structural forces at play. The West Midlands is the industrial heartland of the UK in which 1 in 4 are employed in manufacturing. Many of the SMEs in this activity are part of global supply chains and are thus subject to monopsony power of their customers (the ability of large firms to dictate prices to smaller firm who supply them), for example the car industry. Despite the claims that we live in a web-based knowledge economy, many of these firms seem anachronistic in appearing to be a throw back to earlier times. They often produce low margin products in large bulk, using traditional production techniques on machines whose best days are behind them.

The rapid and sharp decline in world trade in the last quarter of 2008 and first quarter of 2009, created significant difficulties for which they had no strategic response. This is reminiscent of the British film Chance of a Lifetime made in 1950, which portrays a group of angry workers, who in protesting about their wage and working conditions at a plough factory are allowed to take over the operation themselves. It isn't long before they realize that you can't run a business on idealism and goodwill, as a large export order fails and the patrician factory owner returns and comes to the rescue. The only current patrician in town is the government but despite the very large bail-out of the financial system, direct aid in the form of wage subsidies to sustain employment during these difficult times is not on the agenda. This was a proposal made by Danny Blanchflower, but like many of his insights and suggestions, policy makers have ignored them.

King Cash may be in a comfortable counting house...

Rising unemployment in manufacturing is not just the price of defeating deflation, it is the price of lower demand for goods and services; less direct and indirect incomes in the locale and beyond; postponed or cancelled investment; less sustained knowledge and innovation; and very importantly in a UK context, skills. In an economy that has been termed one operating in a ‘low wage – low skills equilibrium’ this is the crucial factor. In exercising his divine right, King Cash may be in a comfortable counting house, but perhaps we need a new republic in which the government creates financial institutions to underwrite our industrial and manufacturing base. Without this base we all may be asked to eat cake by a latter day Marie-Antoinette.

Take it further with Open2

• Negative feedback loops
• Join the debate

Take it further with Open University courses

• Engineering the future
• Strategy
• Economics and economic change

About the author

Leslie Budd is Reader in social enterprise at The Open University Business School. He is an economist and has written extensively on the relationship between regional and urban economics, and international financial markets.

Subscribe to Leslie Budd's posts

 

With most of Britain in the cold grip of winter and the effects of the credit crunch, August 2007 seems a long time ago. That is when one of biggest UK mortgage providers, Northern Rock, raised the alarm that it was finding it difficult to raise funds from the world’s money markets and ushered in the dreaded credit crunch, with the biggest run on a British bank in recent memory. At the time, however, many thought it might remain a local problem. Indeed, the 2007 third quarter Quarterly Survey of Small Business in Britain, which is based in the Open University Business School (OUBS) and has been monitoring small business performance every quarter since 1984, found that the net percentage of small firms reporting increased sales was at a four year high on 26%. On top of that, the net percentage balance of small firms expecting sales to rise in the coming quarter was at its second highest level since the Quarterly Survey began (28%).

very small firms account for more than 95% of all enterprises in Britain

Sadly, it was not to be. In the final quarter of 2007, the net percentage balance on actual annual sales (the percentage of respondents reporting an increase less the percentage reporting a decrease), slumped to just 12% and has continued to fall. Expectations on sales have been negative for the last two quarters of 2008. Not surprisingly, this has had a significant impact on the survival of firms. Furthermore, it appears that the very small firms of fewer than 10 employees are most adversely affected, which is worrying for the entire economy. The latest statistics from the Department for Business, Enterprise and Regulatory Reform (BERR) - show that these very small firms account for more than 95% of all enterprises in Britain and just under one quarter of national sales turnover (23%) but that they also account for most of the closures in Britain’s declining stock of businesses. In fact, closures had already overtaken new start-ups by the beginning of 2007.

The main economic impact of the credit crunch on small firms is now seen in the labour market and its effects on unemployment. The Office of National Statistics December release shows a steady increase in unemployment from the third quarter 2008, heading for the 2 million mark by the end of December and still climbing. With more small firms shedding staff than those hiring, the Quarterly Survey has recorded negative percentage balances for employment since the second quarter 2008 and negative expected unemployment since the end of 2007. The signs of a deepening slowdown have been clear for over a year.

When asked in July about the measures they are adopting to cope with the economic downturn, most small business owners (53%) report that they take a cut in their own earnings and some 38% report that they have cut staff. A further 14% intend to close their business. However, the more entrepreneurial firms seek new markets and business ideas (42%) or increase their marketing and promotion (35%) – as opposed to the 19% who cut their marketing costs.

The trends from national statistics and the Quarterly Survey are not encouraging. Although recessions are often thought to be an opportune time to launch new cost-saving products, processes and services, many small firm owners face a bleak future. Only 18% now expect to have a comfortable pension when they retire and, more worryingly, 8% of small business owners report they do not have any pension provision at all. Consequently, more than one third (38%) will have to continue working longer than they intended. The average age of retirement is likely to be 67 with a significant number resigned to working into their 70s.

About the author

Colin Gray is Professor of Enterprise Development at the OU Business School, where he is responsible for research and teaching in small business and entrepreneurship.

Subscribe to Colin Gray's posts

 

Blogging about

Money Programme

Get the facts behind the big business and finance stories from around the world – and down your street, in The Money Programme.

The past nine months have been traumatic for the global financial markets.

The collapse of the US sub-prime market in 2007 has resulted in many banks incurring huge financial losses as their investments in asset backed securities linked to the US mortgage market plummeted in value.

Yet this was only the first domino to fall over in a calamitous chain reaction of financial events that now threatens the wellbeing of the UK economy and particularly the housing market.

The exposure to losses by banks exposed to the US market quickly led the financial markets seizing up. So called ‘inter-bank lending’ stalled with lenders becoming increasingly wary about which financial institutions to place their funds with.

The domino effect.

[photo © copyright Photos.com]

This quickly led to interest rates in the financial markets rising – an inevitability given the lack of supply of funds – with the result that market rates moved over 1 per cent higher than the Bank of England’s official lending rate (which normally dictates the level of rates in the financial markets).

For institutions reliant for funding on the ‘wholesale’ financial markets – as opposed to the ‘retail market’ of personal savings – this shortage of funds and a squeeze in their cost proved disastrous. The greatest UK casualty was the Northern Rock Bank: with nearly three-quarters of its funding coming from the wholesale markets the bank quickly found that it could not finance its existing mortgage loans and other assets. Ignominiously it was forced to seek help from the Bank of England. What happened next is well known: the personal investors who had funds at the Rock queued to get their money out. This forced the UK government and the Bank of England both to guarantee the Northern Rock’s savings liabilities but also to step in and provide a ballooning level of financial support in excess of £25bn as investors withdrew their money. Eventually in March 2008 – after a failed attempt to organise a sale – the government was forced to nationalise the bank.

For other, more prudent, UK mortgage lenders the ‘knock on’ consequences of the Northern Rock debacle were severe. First they suffered from the higher cost of funds as institutions reduced their lending to the sector – despite the fact that these mortgage lenders had materially less dependence on the financial markets for funds.

With limited funds, falling liquidity and a higher cost of funding mortgage lenders started to raise the cost of mortgages – despite three cuts in UK base rates initiated by the Bank of England taking rates down to five per cent. Additionally funds started to become less readily available with products being withdrawn, and the deposits needed to obtain mortgages rising. Mortgage approvals in April were the lowest since records began in 1993. The days of readily available mortgages – and those offered at 100 per cent of the value of the property being purchased – have now disappeared.

"the nice decade is behind us"

With mortgage availability decreasing the demand for property has fallen. Consequently, property prices have started to fall.  House prices are now, on average, around four percent lower than their peak in October 2007.

The weaker position in the housing market is only making it more difficult for mortgage lenders to borrow money in the financial markets thus reinforcing the vicious cycle – this despite some late efforts by the Bank of England to inject liquidity into the financial markets by taking mortgage backed assets from the mortgage lenders and swapping them for government bonds which may, in turn, be used collateral for borrowing cash.

Perhaps the only winners from this situation are first-time buyers, who may now have an easier step up to that first rung on the housing ladder, and investors, who are now seeing mortgage lenders compete aggressively for their funds by raising savings rates.

As for the housing market – tighter credit, limited funds and the prospect of a buyers’ ‘strike’ spell bad news for house prices and hence for the quality of mortgage lenders’ balance sheets. Mortgage arrears and repossessions may not have risen substantially yet – thanks to the continued buoyant level of employment - but a slower housing market spells slower UK economic growth and, in due course, higher unemployment.

With the added strain of higher food and utility costs and soaring petrol prices household budgets will be coming increasingly under pressure – and there will be less credit available to bail them out. Thus upward pressure on arrears and then repossessions could be the next stage in an uncomfortable scenario for the UK housing market and the mortgage lenders.

As Mervyn King, the Governor of the Bank of England, remarked a few days ago ‘the nice decade is behind us’. Certainly, with the shrinking availability of mortgages, the decade of booming house prices is well and truly behind us.

Weblinks

Northern Rock: a business model unravels
Why do we get into debt? – is debt always a bad thing?
You and Your Money – don't let your money be the boss of you, get help from our interactive
Property slowdown ahead? – expert views
Moneymadeclear – guides and advice from the FSA

Join the discussion

Courses

You and your money: personal finance in context
Understanding economic behaviour: households, firms and markets

Take it further – the Open University Business School offer a range of courses covering personal and institutional finance issues.

About the author

Martin Upton is lecturer in finance at the OU Business School. Previously he spent 20 years in treasury management, including 12 years as Treasurer of Nationwide Building Society. Martin's particular interests are financial services, the housing market, financial markets and risk management.

Subscribe to Martin Upton's posts