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.