Sunday 19 February 2012

Save the Euro – Get Connected: Why Countries with the Internet have Lower Cost of Borrowing

This snapshot of a handful of countries post-economic crisis shows one thing very clearly: a country’s ability to weather the economic crisis is related strongly to its level of modernisation or e-Intensity.

 Note: e-intensity is a measure developed by the Boston Consulting Group based on adoption, expenditure and use of the internet and e-commerce. Our analysis puts e-intensity against 10 year government bond rates as our measure of how well a country is weathering the economic crisis.

The results of our simple analysis are particularly striking within the Eurozone. Member states which have not had the capacity to adopt and develop the internet and ecommerce are those with skyrocketing risk premiums on their governments’ debt. These states form a distinct group: Portugal, Italy, Spain, Ireland and Greece (which is literally off the scale) - all with high debt premiums and an e-Intensity score of well under 100.

There are two other groups: those with high e-Intensity and low government bond rates such as Germany, Denmark and the UK, and a middle group (Belgium, Austria and France) with lower e-Intensity (100-120) and raised bond rates of 3-4%.

So why is there such a close relationship? There are two possible explanations, and both could be correct:

a) Low e-Intensity indicates underlying structural problems: countries with high e-Intensity are those which have invested in modern processes, improved productivity and benefit from strong institutions. These are the countries that have lower borrowing costs, as they are best placed to grow their economies in the future.

b) e-Intensity (or what it represents) is a fundamental capability: countries which use the internet intensively can respond more flexibly to shocks and crises, instead of being weighed down by cumbersome 20th century processes and institutions.

What makes these two explanations compelling is the following: if you can get a country to invest in, use, and compete on the internet, then you must have either eliminated or minimised any underlying structural problems, or created a flexible and robust economy, or both.

Five of the countries shown here (Greece, Portugal, Ireland, Spain and Italy) have been slow to embrace new technology, business models, and to change consumer behaviour. Much has been written about the institutional problems these countries face, but we think a very specific problem might lie at the heart of the current economic crisis: how do you get these countries to invest in and use the internet? And both investment and use are necessary – just buying infrastructure and fancy web sites won’t cut it.

Our questions:

1. Is the internet a line in the sand for Europe? Does a country’s ability to adopt and exploit modern technologies dictate whether it can operate within the single currency?

2. Can the problem be addressed in time? Does this highlight a structural issue that takes decades to solve, or is it a faster acting killer-policy-app for the Eurozone’s troubled economies that could keep them in the single currency for good?

3. Should investment in e-Infrastructure and stimulation of usage become a policy priority for Europe?

We will answer question 3: “Yes, immediately”. Of course, further evidence is needed and linkages need to be demonstrated, but the risks are high and the expensive parts of the solution - infrastructure investment - can have well-calculated returns.

Whatever the underlying mechanisms, it is clear that the internet is playing a very significant role in modern economies, and one which may extend far beyond its direct share of GDP.

About the Authors of this post:

David Cleevely is Founding Director of the Centre for Science and Policy at the University of Cambridge.

Matthew Cleevely is an entrepreneur pursuing a PhD in entrepreneurship, innovation and growth policy at Imperial College Business School, London

The BostonConsulting Group e-Intensity Index (BCG Perspectives) used in this analysis compares different measures of Internet activity for 50 countries. It measures the three significant factors:                                                                       
i.                Enablement. How well built is the infrastructure and how available is access? (This has a weighting of 50 percent.)
ii.               Expenditure. How much money is spent on online retail and online advertising? (25 percent.)                                                                        
iii.              Engagement. How actively are businesses, governments, and consumers embracing the Internet? (25 percent.)

Tuesday 14 February 2012

The Macmillan Gap (Part 2 of m)

How many theories should you think about when investigating SME support?

In investigating the Macmillan gap, a question occurred to me: How many theories are there now for which intervention in a space is justified? Academic thought has obviously moved on since 1931 (one hopes) to identify more completely the number of specific failures in the area of SMEs. Any new government action to help growth, SMEs, entrepreneurs, innovation and should take into account modern, accepted theories. But how many driving theories are there?

Easy, 11½.

My reasons for this are simple. Imagine I invent an important new reason and method for intervening in within a specific field, say SME support. People like the reason, and so in business, academia and political circles it is accepted as a good thing to start doing.

Now any existing government agency that is already in the field sees the benefit and justifiability of expanding their empire to encompass this new activity in some way. This includes the politician, who, may chose to address it specifically by creating a new agency of some kind.

So for each new reason to act in the SME area discovered, all existing actors create a new scheme to address it.

The next time someone invents a perspective on intervention or identifies an aspect of market failure, all the previous schemes and all the new ones from my idea will now start creating their own new scheme. The n-1 schemes in existence launch n new schemes (the policy maker launches one as well).

As a result the number of schemes = 2^(the number of important reasons for intervening)-1. Assuming that we never lose any of these – winds of creative destruction rarely blowing through Whitehall then the number of theories is trivial: If we know the number of schemes (much easier than identifying the important theories!) then we know that the number of theories is just Log to the base two of this number.

Well, in 2008 the Richards report (which I contributed to in a very small way) answered this question: About a three thousand, hence 11½. So one might “reasonably” expect around 10 major theories, observations or driving factors behind government intervention in small business support.

I have previously stipulated that there were only two ways of solving a single identified problem in the 40’s and 50’s of the Macmillan gap. These were government backed lending to SMEs and Angel or high net worth individual lending. The latter of which had been identified and accepted as an area for intervention that lead to the formation of the ICFC. So there was one government scheme in 1945 with one theory, and 3,000 in 2008 with 11½. I’ll be getting on with finding the other 10½ theories then.

Wednesday 1 February 2012

The Macmillan Gap (Part 1 of m)

The Macmillan Gap (c.1931) vs the SME funding gap (c.2012).

As discussed in my first post most problems have been thought of and solved somewhere, in someway before. In this post I explore the Macmillan Gap, a fascinating problem to which a solution was first created in 1945 which holds important lessons for today. I believe it is an essential consideration in modern innovation and entrepreneurship policy in the UK. This will be the first post of many (a currently unknown number, m) on this subject.

Three questions are immediately apparent when looking at how an old problem might inform policy today: What is the nature of the problem it addressed? what was the solution? and why did it fail?

Keynes and Bevin, amongst others, submitted to the Macmillan Committee (1931) that there was a gap in SME funding in the UK. Macmillan’s 1931 report states (Numbers adjusted to 2010 prices):

“It has been represented to us that great difficulty is experienced by the smaller and medium sized businesses in raising the capital which they may from time to time require even when the security offered is perfectly sound. To provide adequate machinery for raising long dated capital in amounts not sufficiently large for a public issue i.e. amounts ranging from £150k, say, £8m or more, always presents difficulties. .”– The report of the committee on Finance and Industry, June 1931. Numbers adjusted to 2010 prices.

This is the same problem that exists in the UK today – frequently referred to as a gap in the funding escalator, or just the funding gap – that is varyingly stated at between £200k-£8m (usually toward the lower end).

So what was the solution, and how did it work? In 1945 the government created what we would now call a small business bank, the ICFC (Industrial and Commercial Finance Corporation for Industry).

~~Deep breath, and rose tinted specks firmly attached~~

The ICFC was set up to self-fund by specifically lending in to the Macmillan gap. It could lend in flexible ways (it was backed by govt. & big bank investment + borrowing), provided expertise locally (including changing loan terms in tough times), and had no requirements for post-investment liquidity (it was not shareholder owned so no need for a quick payoff). Loss making loans at the smaller end of the gap were subsidised by the more profitable loans with larger scales.

It had the flexibility to choose the appropriate investment tool for each investment; in 1953 the ICFC had leant most of its available capital with 37% of investments in preference and ordinary shares (4:1 ratio between the two), and 63% in secured and unsecured loans (2:1 ratio between the two). And in 1953, only 10% of investments were in liquid (quoted) assets.

Its services were in demand and it addressed the Macmillan Gap. So why did it fail?  It failed because the ICFC was allowed to turn into a commercial success; it succumbed to the pressures that first created the Macmillan gap. Those pesky loss making small-scale deals weren’t nearly as exciting or money making as larger scale venture finance:

By the 80’s the ICFC hand changed. In 1967 the ICFC started to do M&A work, expanding its reach into larger deals. Multiple recessions (’74 and ’81) eroded the banks financial balance sheet, which put policy makers in a tough position; either they could prop up the ICFC (now the FFI), which would require more investment (a cost!), or they could allow it to stop its less profitable activities. The ICFC itself wanted to be able to behave like its market based peers.

These pressures led to a complete loosening of its original obligations in 1981, and through the 1980s it funded large numbers of management buy-outs and ceased the boring banking function at the smaller end of the scale. It was renamed 3i before its flotation in 1987.

In becoming a commercial success, 3i had re-opened the Macmillan gap.

The forces that created the Macmillan gap eroded, over time, the institution created to bridge it.

Three final thoughts:

To have an equivalent impact today a new bank would need to match the expansion in the UKs economic activity. Adjusting for GDP growth and prices, the ICFC today would require £2.5bn of upfront investment with the capability to borrow a further £4.5bn. £7bn in total, quite a sum.

The current credit squeeze hitting lending to SMEs is not the Macmillan Gap – it is exacerbated by it. But wouldn’t it have been nice to have an institution ready to go that operated right in that gap? One of the issues facing the government is that it seems to lack the institutional levers that would allow it to tackle the issue head on. It now should be thinking seriously about changing the tools it has available.

The Macmillan Gap is just one way of looking at the phenomena of small businesses. There have been great advances in theories of SMEs, gazelles, innovation etc. that mean there are even more potential ways of tackling this issue… I’ll save that thought for my next post.