Haircuts for small businesses

Haircuts for small businesses

Ross H. McLeod, Editor, 'Bulletin of Indonesian Economic Studies',
Canberra

An interesting policy suggestion that has been made in recent
times is that small businesses with outstanding bank loans should
be given haircuts. The purported rationale for this is fairness.
Firms owned by the conglomerates allegedly have been given
haircuts, so to be fair, small firms should be given haircuts as
well.

The term haircut (debt forgiveness) made its first appearance
only during the last four years or so, after countless firms
became deeply insolvent, and it became clear that such that
haircuts would be necessary if they were to be revived.

This is not really a new phenomenon, however. All that has
changed is the name. Recall the large-scale lending by state
banks to farmers and small businesses in programs such as mass
guidance (Bimas) credit, small investment credit (KIK) and
permanent working capital (KMKP). Very widespread loan defaults
unilaterally decided haircuts were always a problem in these
programs. What is different now is the suggestion that this
should be a conscious policy of the government.

Of course, giving away money was not the nominal intention of
these earlier programs. Small businesses and farmers were being
given loans that they were supposed to repay in full. But anybody
who had the slightest understanding of the business of banking
would have been aware that a high level of arrears was
inevitable.

Some argued that the programs addressed problems of market
failure that allegedly resulted in discrimination against small
borrowers. But there is no doubt that they were simply intended
to redistribute income: To buy support for the government, or at
least to buy off opposition to it.

In any case, the apparent redistributional impact of these
programs was largely an illusion. Under the Soeharto regime very
large loans at subsidized rates were also being given to the
conglomerates, and the loans to small businesses and farmers in
aggregate were small by comparison. Taking all the subsidized
loan programs of the state banks together there was indeed some
income redistribution going on, but it was redistribution mainly
in favor of the wealthy.

The subsidized loan programs for farmers and small businesses,
with their implicit inbuilt haircuts, were disastrous for the
state banks. It added to their other losses and contributed to
the need for them to be recapitalized from time to time. (Bank
failures and recapitalisations are nothing new in Indonesia, at
least among the state banks.) Heavy subsidies to small businesses
and farmers were considered acceptable at the time, however. This
was mainly in the 1970s and early 1980s, at the height of the oil
boom, and many considered it desirable to use some of Indonesia's
oil revenues for this purpose.

Circumstances now are completely different. Indonesia is
facing enormous fiscal problems that will continue for many years
to come. It seems almost inconceivable that anyone can be
advocating consciously implementing a policy of blanket haircuts
in such circumstances.

Aside from the question of the budgetary impact, another
important factor to be taken into account is the implications of
a blanket debt write-off for small businesses in the future. If
this write-off were to be implemented, which bank would want to
gamble on lending to small businesses in the future?

This short-sightedness has always been a problem for small
business in Indonesia. There has always been a strong aversion to
allowing lenders to seize the assets of small borrowers if they
default on their loans. In other words, there has always been an
inclination to allow haircuts, in effect, for small borrowers who
have difficulty in repaying.

What the supporters of this "softly-softly" approach fail to
realize is that this severely weakens the incentive to lend to
small businesses in the first place. It sends a clear message
that lenders should not count on getting their money back if they
do so. From the point of view of allowing small businesses to
continue to be able to borrow on reasonable terms in the future,
no policy could be so counterproductive as a blanket provision of
haircuts for small business borrowers.

We should also consider the equity aspects of the proposed
policy: After all, the argument in its favor is that it is
supposedly fair. What the proponents of this policy don't seem to
take into consideration is that if somebody is given a subsidy
which is what a haircut amounts to somebody else has to pay for
it.

It is not the conglomerates that would pay for this haircut.
The bulk of the banking sector is now owned by the government, so
any loss that banks incur by way of having to write off a
significant portion of their loans to small borrowers would
result in a similar loss for the government and therefore, to the
general public. In turn, this will be felt in the form of reduced
provision of education, health, law and order and so on, all
which are beneficial to the poor.

Finally, it should be emphasized that the owners of small and
medium enterprises are not Indonesia's poor. The genuinely poor
do not have outstanding loans from banks. Years ago I made a
rough calculation of the size of the implicit subsidy to the
small business borrower with a typical KIK/KMKP package, and
found that it was equivalent to about seven times the annual
income of an Indonesian laborer. And this subsidy was derived
merely from the low interest rate on these loans: Imagine how
much bigger it becomes with a 30 percent haircut in other words,
an interest rate of minus 30 percent.

Therefore a blanket write-off of debt of small businesses in
Indonesia would be grossly inequitable, just as the KIK/KMKP
program was. It would provide a large, short-term gain to those
who happen to have outstanding loans from banks at the moment.

Other small businesses who have financed their activity from
their own savings, or who have borrowed outside the banking
system, would get nothing. The policy would severely damage the
borrowing prospects of small firms in the future, and the costs
would be borne by the general public, especially the genuinely
poor.

The above was presented at the Tribute to Prof. Heinz Arndt
held by the Centre for Strategic and International Studies in
Jakarta on May 31.