After reeling from one crisis to another, Europe’s heavily indebted and deeply debilitated small businesses — the backbone of the economy — face the ultimate threat from energy shortages and soaring prices.
With the specter of stagflation looming large over Europe and the price of energy rising at a blistering pace, hundreds of thousands, perhaps even millions, of small businesses face the grim prospect of closure this winter. In the UK, much of the news cycle in recent weeks has been dominated by the plight of struggling families grappling with surging energy bills. But many businesses are, if anything, in an even worse pickle, since they don’t have price caps on the energy they pay. Some business owners are facing an increase in bills of more than 350%.
Unsurprisingly, energy-intensive businesses, including bars, restaurants, hotels, hairdressers, small manufacturing and construction firms, are absorbing the worst of the pain. Fish and chip shops could even be facing “extinction”, warned a recent article in the BBC, as a trifecta of forces — surging energy prices, shortages (and hence rising prices) of other basic inputs (potatoes, some fish, sunflower oil), and falling demand among cash-strapped customers — take their toll.
The Final Straw?
Across Europe small and medium-sized businesses (SMBs), particularly in sectors like travel and tourism, culture and hospitality, have borne much of the brunt of the economic fallout of the pandemic. The stimulus packages — including furlough programs, debt moratoriums and low-interest emergency loans — helped to tide over many (but not all) of the worst-hit businesses but that support has ended. Meanwhile many of the economic problems spawned by the pandemic, including supply chain bottlenecks and labor shortages, continue to linger. Energy shortages and surging prices are likely to be the final straw.
In the UK, some energy providers are even refusing to supply small businesses out of fear they could go bust. Some are demanding £10,000 upfront, according to The Guardian:
In the latest sign of the deepening energy crisis, business owners said they were struggling to find a supplier in the run-up to the busy October period for renewing gas and electricity contracts, leaving them facing “extortionate” bills or demands for a deposit.
Suppliers named as having refused service, or asked for a downpayment, include SSE, Scottish Power, E.On Next, Drax and Ecotricity.
Business owners called for urgent action from the government, warning that sectors such as hospitality, which is already struggling with inflation and the lingering effects of the Covid-19 pandemic, are at particular risk.
Teresa Hodgson, landlord of the Green Man pub in Denham, near Uxbridge, was initially told by her supplier SSE that it could not give her a quote for energy because prices were increasing so fast. “When I did pin them down, they said before we can go any further, we want a £10,000 deposit,” Hodgson said.
“When I asked why, because they’ve never had an issue with me, they said: ‘We don’t think a lot of pubs are going to make it this year and we need security.’ There were other suppliers who just wouldn’t entertain it at all because it’s hospitality,” she added.
Many small in-person businesses only managed to weather the lockdowns of 2020-21 by taking on huge amounts of debt, which they now have to pay off. The only way the debt gets cancelled is if the business in question goes into insolvency. According to research published by the Bank of England in November last year, 33% of small businesses have a level of debt more than 10 times their cash in the bank, versus 14% before the pandemic. Many of those businesses had never borrowed before and some would probably not have met pre-pandemic lending criteria.
In total, £73.8 billion has been lent under the UK’s coronavirus emergency lending programs — the equivalent of 3.5% of GDP. Almost two thirds of that money — £47 billion — went to 1.26 million small businesses — in a country of roughly 5 million businesses. Through the Bounce Back Loan program SMEs were able to borrow up to 25% of their revenues to a maximum of £50,000. The loans, interest-free for 12 months, are administrated by private-sector banks, but are 100% backed by the government.
Suffice to say, the government does not expect to recoup much of the money. In 2021, the Department for Business, Energy and Industrial strategy estimated that 37% of Bounce Back Loans, worth around £17.5 billion, may not be repaid, mainly because the businesses concerned would not survive over the longer term. Other estimates are even higher. The department has already written off £4.3 billion of Covid loans due to fraud. Since banks were not liable for unpaid debts from the BBL scheme, they were happy to release the funds with little in the way of background checks, thus creating a goldmine for enterprising criminals.
But that write-off is likely to be eclipsed by around £20 billion in expected loan defaults as businesses fail to repay their debts, Duncan Swift, a restructuring and insolvency partner with Azets, told City AM in February. That was just before Russia’s occupation of Ukraine and the EU and UK’s subsequent decision to unleash arguably the most self-destructive sanctions of modern history. Since then inflation in the UK has surged to 10.1%, its highest reading in 40 years. For many small businesses, passing on rising input costs to customers is not an option. That is particularly true in the case of soaring energy prices, which threaten to be the final straw for many struggling companies.
Deja Vu in Southern Europe?
In the meantime, the European Union is no doubt growing increasingly concerned (or at least one would hope so) at the risk of rising default rates in the two systemically important economies of Southern Europe, Italy and Spain.
A sense of deja vu should be setting in by now as the yields on Italian 10-year bonds hover around eight-year highs of 4%. According to the Financial Times, “hedge funds have lined up the biggest bet against Italian government bonds since the global financial crisis on rising concerns over political turmoil in Rome and the country’s dependence on Russian gas imports.” On Friday, the European Commission quickly and quietly gave its blessing to Italy’s latest plan to shift certain state-guaranteed loans from banks to a new platform managed by state-owned bad loan specialist AMCO, ruling the move free of any state aid.
“This scheme will enable Italy to maximise the recovery of loans while reducing the impact of the existing state guarantees on the national budget and the effects on the borrowers with good prospects of viability”, EU Competition Commissioner Margrethe Vestager said. The Commission also pointed out that, under the scheme, Rome will be remunerated in line with market conditions, meaning it will be paid a tiny fraction of the loans’ original value.
This is probably just the beginning of what is likely to be a long, painful process, given that Italy underwrote €277 billion in COVID-related corporate debt during the pandemic, significantly more than many other European countries. Some of the 2.7 million small and mid-sized (SME) Italian businesses that took on state-guaranteed debt are now on the sharp end of skyrocketing electricity and gas prices, which is impairing their ability to honour the debts. According to Rai News, small firms in the tourism and services sectors face an additional €8 billion in costs over the next 12 months as a result of the energy crisis.
“Without support, the system of small businesses will be crushed by these cost increases,” said Patrizia De Luise, president of the retail association Confesercenti. “The government in office should act using all the powers at its disposal.”
But Italy, like the UK, currently has a caretaker government in office. What’s more, the root cause of the problem is in Brussels, not Rome. As Yves pointed out in her article yesterday, the EU’s wholehearted support of a sanctions regime against Russia is not only backfiring spectacularly; the damage it is causing to the West, most of all Europe, is accelerating rapidly. While in the UK new regulations could possibly be introduced to ease the price pressures (see “We Could Massively Reduce the Price of Energy in the UK – By Changing the Way We Regulate Energy Prices“), in the EU any significant regulatory changes would almost certainly have to come from Brussels.
Italy’s Debt Disappearance Act
The good news is that Italy’s non-performing loans (NPL) ratio is currently at its lowest level since the Global Financial Crisis. The bad news is that this is largely thanks to the mass-securitization of Italian banks’ huge trove of toxic loans. Over the past five or so years, Italian banks, with help from Wall Street’s finest, have been slicing, dicing, and repackaging non-performing financial assets, such as loans, residential or commercial mortgages, or other sometimes uncollateralized Italian “sofferenze” (bad debt) into asset-backed instruments which can then be sold to yield-starved gullible investors all over the world.
As part of a deal reached with the European Union in January, 2016, Italian banks were given permission to bundle bad loans into securities and buy state guarantees for the least risky portions, provided those notes have an investment-grade credit rating. So the taxpayer would not only be on the hook for a portion of the NPLs underlying these securities, but also for the fees and profits generated along the way to securitize them. As I noted in a 2017 piece for WOLF STREET, this was far riskier than the subprime mortgage-backed securities in the US that played a major role in the global financial crisis:
The FT describes the idea of securitizing NPLs as “subprime derivatives on steroids,” but only in relation to China’s plans to do exactly the same thing with its own non-performing loans, which according to official figures recently surpassed the $200 billion mark. The FT has been a lot less critical of the same plans being hatched in Italy. Some economists are even calling for a Europe-wide securitization of toxic debt.
So, while this scheme has allowed many of Italy’s largest banks to shift most of their toxic assets off their balance sheets, thereby reducing the immediate threat of a banking crisis, it has put Italy’s already over-indebted government, with a public debt-to-GDP ratio of 150%, on the hook for a large chunk of these securities should they suddenly begin to collapse in value. It will also be interesting to see what happens with these “subprime derivatives on steroids” as interest rates climb and growing numbers of heavily indebted Italian businesses and households stop paying their debts all over again, this time due to soaring energy costs.
Il Sole reported just today (August 30) that Rome is currently working on a bank rescue fund for Italy’s smallest lenders. The scheme will apparently be financed by Italy’s largest lenders, which are not exactly in the rudest health themselves. Banco BPM and Intesa respectively place second and eighth in a list compiled by Bloomberg of the large European banks with the highest NPL ratios. Spain’s four largest lenders (BBVA, Caixabank, Santander and Sabadell) are all in the top ten. As the Spanish financial daily Cinco Dias reported in mid-August, business loan delinquencies in Spain reached €349 billion in the first quarter of this year, up 42% on the same period of 2021.
“Debts owed by companies continue their upward trend at a worrying rate,” the newspaper warned. As with their Italian peers, most (but not all) of the business loans issued by Spanish banks during the pandemic was guaranteed by the State.
Backbone of German Economy Beginning to Buckle?
There are few places in Europe, if any, where small and medium-sized businesses are not reeling from the multiple economic shocks of the past two and a half years. The backbone of Germany’s export-driven economy, the so-called “Mittelstand”, is also showing signs of strain. Consisting almost exclusively of “classic” SME-type firms (with revenues below 50 million EUR), the Mittelstand accounts for a staggering 99% of German firms. The “upper”-sized Mittelstand firms (with revenues between €50 million and €1 billion) are the most export-oriented group of firms in Germany’s business landscape, contributing significantly to Germany’s sustained export success.
But many of them are in big trouble as the scarcity (and high prices) of energy, other commodities and components they depend upon makes it harder and harder to manufacture the goods they produce at a competitive price. And if the Mittelstand is in big trouble, so too is Germany. According to an article in Der Spiegel, 42% of 853 companies recently surveyed by the Federal Association of Medium-Sized Businesses (BVMW) said the explosion in energy prices pose a threat to their survival. Almost three quarters of the companies said they were suffering as a result of the current energy prices.
As economic conditions in Germany deteriorate, public support for Olaf Scholz’s government is collapsing. News magazine Focus ran a headline yesterday referring to Scholz as the “weakest chancellor of all time”:
According to a new Insa survey, 62 percent of Germans are dissatisfied with Scholz’s work, more than ever before. Only 25 percent rate the chancellor positively. In a comparable survey at the beginning of March, 46 percent of those questioned were still satisfied with Scholz’s work, only 39 percent stated that they were dissatisfied with it. The chancellor’s fall in reputation is taking place quickly and violently.
If the Germans could vote again today – Scholz would no longer be chancellor. In a direct election, Olaf Scholz would finish a pitiful 18 percent behind Vice Chancellor Robert Habeck and now also behind opposition leader Friedrich Merz (CDU).
For many of Germany’s small businesses, the damage may unfortunately already have been done. The same goes for legions of small businesses across the continent. If they fall, the effect on the economy is likely to be significant. After all, small and micro businesses make up the vast majority of businesses worldwide, representing around 90% of businesses and around half of employment globally. A mass extinction event could also trigger another crisis for Europe’s ever-fragile and fragmented banking system.
Just as importantly, as I note in my book Scanned, “small businesses are the cornerstone of local communities, providing basic products and services, creating jobs, allowing local economies to flourish, and providing spaces and places for people to meet and engage with each other.” A world without them will be a much poorer world indeed. It will also be a world even more dominated and controlled by global corporations.
