The European Central Bank is starting to purchase sovereign bonds this month, but what if quantitative easing is not the answer to Europe’s problems?
Of course, investors have been buying European equities in anticipation, and risky assets have seen a revival. But to really solve the issue that is at the core of Europe’s crisis, policymakers need to look at its small companies, which are in fact the continent’s main sources of jobs.
ECB President Mario Draghi has said as much. He repeated in every news conference that QE is just one measure, and that governments in eurozone countries need to do more to kick-start growth.
It turns out that they might have an even harder job than previously thought.
A green paper published recently by the Centre for Economic Policy Research (CEPR), a network of over 900 research economists based in European universities, notes that while there is little evidence of a shortage of long-term finance for companies that have access to bond and stock markets, it is the small and medium size firms that suffer.
In Europe, the small and medium size sector’s problem weighs heavily on the continent’s economy – especially as QE policies tend to help bigger companies rather than the small ones.
The official definition of a small or medium size enterprise is a company that employs fewer than 250 people and has an annual turnover below 50 million euros ($56 million) and/or an annual balance sheet under 43 million euros.
There are 21.3 million small and medium size enterprises (SMEs) in the European Union, making up more than 99% of all companies and employing 88.6 million people, or 67.4% of the total jobs.
Spain and Italy have the highest proportion of micro companies, according to some studies. Other studies have shown that the European countries with the highest prevalence of SMEs had the worst economic downturns during the financial crisis.
Another factor highlighting the importance of SMEs is the fact that their return on equity and return on assets are higher than for other categories of companies.
However, there are big differences between countries. German SMEs, followed by UK and Dutch ones, are the most profitable.
Source: Centre for Economic Policy Research (CEPR) Green Paper.
SMEs are much more dependent on bank credit than other firms, who can issue shares or corporate bonds. This is why they have faced significant headwinds since the crisis, and it looks like this is a vicious circle. More stringent regulation imposed on banks in the wake of the crisis means they are shunning risky assets even more — and SMEs are certainly considered risky.
Alternative financing sources, including private equity, are limited for SMEs because of investors’ reluctance to put money in companies that are considered fragile and much more exposed to risk – whether that opinion is justified or not.
In a book he launched last year, a UK-based fund manager who focuses on small companies argued that in fact these are much better placed to weather economic downturns, because they are more flexible and not that exposed to global headwinds.
The banks certainly don’t see it that way. The CEPR report found that the collateral and guarantee requirements for SMEs “are becoming more onerous,” with the number of companies needing guarantees on the rise.
Three quarters of these guarantees were provided by owners or creditors of the company. And while bigger companies could replace bank credit with corporate bonds, SMEs had to increase their reliance on trade credit to make up for lost bank loans.
New sources of financing have appeared, particularly crowdfunding and peer-to-peer lending, but those are still in their infancy.
The ECB’s asset purchases will help the eurozone’s economy to some extent, as they weaken the euro, making exports more competitive and proving to speculators that the central bank stands ready to defend the eurozone from fragmentation via bond yields.
But at the end of the day, the ECB cannot provide loans to SMEs. For that, policymakers may have to tear up the rulebook and start afresh.