Is the Government's Intervention in the Bank Loan Market Justifiable?: Examining the Effect of the Special Credit Guarantee Program
What is needed in the debate on public finance reform
Currently, the government is pushing forward a plan to overhaul the nation's public finance system, redefining the roles that should be played by quasi-governmental financial institutions. In doing so, it is necessary to clarify why the government needs to take a hand in capital flows to private sector companies. In economic theories, such government interventions are justified on the ground that the government takes over borrowers' credit risks and generates information about those borrowers. However, debates over the legitimacy of government intervention are mostly confined to theoretical clarification and thus, in many cases, such government schemes have not been empirically verified for their economic effect (see note 1). In this column, I would like to focus on the special credit guarantee program implemented in the late 1990s, whose effects still exhibit pros and cons, and introduce the results of our empirical analysis of this scheme (see note 2).
Special credit guarantee program as an unprecedented type of government intervention scheme
In the recession period subsequent to the bursting of the economic bubble, the Japanese government intervened in the bank loan market at a scale and with substance previously unseen. A series of measures the government implemented during this period of time provide valuable materials for economists in considering the significance of government interventions. The prime example of these is the special credit guarantee program for small and medium-size enterprises (SMEs), a newly established system to cope with the savage credit crunch, which peaked in the fall of 1998, and the resulting problems such as an increase in the number of corporate bankruptcies. Not only in Japan but also abroad this scheme was by any standard unparalleled: in size (the government's repayment guarantees worth ¥30 trillion, an amount representing roughly 10% of SME loans then outstanding nationwide), in duration of the program's applicability (October 1998-March 2001), and in screening criteria (a guarantee was provided to all applicants except for those classified under a certain item on the negative list such as bankruptcy or tax delinquency). At the time, it was expected that the program would play a far greater role, for better or for worse, than the quasi-governmental financial institutions directly providing loans to SMEs. Thus, quite a few members of the relevant regulatory authorities were cautious about introducing this powerful yet potentially dangerous drug of a program.
Now, let me sort out two contradictory effects that had been assumed in implementing the special credit guarantee program. First, there was supposed to be a positive effect; the program, under which the government sector takes over borrower companies' credit risks, would alleviate the credit crunch by commercial banks thereby enabling the borrowing companies to undertake potentially profitable business projects. In 1997 and 1998, the Japanese economy was in the doldrums. Banks were becoming stringent in their lending policies due partly to successive failures of some of the major financial institutions, and cases of kashishiburi (reluctance to lend) and kashihagashi (recalling of loans) vis-a-vis SMEs were frequently reported. Thus, the special credit guarantee program was counted on to ease banks' rigid lending attitudes toward SMEs. At the same time, however, there were concerns over the negative aspects of the program. Typical examples of potential problems included the possibility of adverse selection, a situation where only companies with low profitability would resort to using the program, as well as of moral hazard of user companies, a situation where SMEs utilizing the program would slack off in their efforts, released from banks' monitoring. It had been perceived that these problems must have been particularly serious with the special credit guarantee program, under which a large number of applications were filed, mostly without any collateral, and accepted without sufficient prior screening by prefectural credit guarantee corporations. Indeed, there have been media reports about problematic cases; some companies used funds obtained in guaranteed loans to purchase shares for investment, some others asked for guaranteed loans simply because they were entitled to do so even though they had no specific needs or plans for using funds, and some companies went bankrupt one month after obtaining guaranteed loans.
Special credit guarantee program made a positive impact on the economy
Which of these two effects prevailed? For an answer, we tracked a total of some 3,500 users and nonusers of the special credit guarantee program and examined how the user companies' performance changed before and after the use of the program. We found the following characteristics when comparing the performance of the user and nonuser companies:
- Both the overall and long-term debt ratio increased while short-term debt ratio decreased.
- Capital investments increased substantially though not to the extent of the increase in borrowings.
- Profitability measured in terms of return on assets (ROA) improved generally and a clear improvement was observed at companies with low credit risks.
The positive effect -- that is, the government's taking over of credit risks of companies leads to an increase in banks loans thereby encouraging borrower companies to undertake businesses with greater profitability -- exceeded the negative effect of moral hazard and/or adverse selection in which companies would invest only in projects with low profitability. Thus, it is fair to conclude that the government's special credit guarantee program had a positive effect in helping improve the efficiency of SMEs. This also serves as evidence of the legitimacy of the government's interventions in the loan market.
Issues for future consideration
This, however, does not give carte blanche for the government to use the same scheme in the future, that is, if encountered with yet another financial crisis. First of all, in addition to confirming the benefit in the form of improved efficiency of surviving companies, it is necessary to examine whether the credit guarantee program brought a significant decrease in the ratio of exiting companies as well as whether the performance of those companies was actually so poor that they deserved to be forced out of the market (see note 3). Furthermore, it is said that the amount of payment in subrogation under the special credit guarantee program has reached ¥2.1 trillion. To be sure, not all that amount will result in additional fiscal burdens. Still, questions will be raised about the scale of fiscal expenditures required under the program and its appropriateness vis-a-vis its overall benefits, including the benefit of circumventing what appeared to be an imminent financial crisis. Second, some sort of improvement must be made with respect to the fact that the program failed to have a positive effect on companies with high credit risks. One way to do this may be adopting more stringent requirements for providing credit guarantees for high-risk companies, such as collecting higher guarantee fees and/or requesting collateral, so as to encourage them to undertake profitable business projects.
It has been reported that the Small and Medium Enterprise Agency is now trying to revamp the existing credit guarantee system with the aim of increasing the effect of the government interventions in the loan market, including the introduction of partial guarantees and flexible guarantee fees. I do hope that the results of our studies will be utilized, in some way, for future policymaking.
- Regarding the effect of loans extended by the Development Bank of Japan (DBJ) in boosting corporate capital investments, there are some preceding empirical studies such as Masaharu Hanazaki and Kazuyo Hachisuka, 1997, "Kaigin-yushi to kigyo no setsubi-toshi" ("DBJ Loans and Corporate Capital Investments"), Chapter 11 of Macroeconomic Dynamics (edited and compiled by Asako and Otaki). Also, recent policy evaluation reports on the Japan Finance Corporation for Small and Medium Enterprise (JASME) provide evaluation on the influence of JASME loans on the corporate default rate.
- For details, see Iichiro Uesugi, Koji Sakai, and Guy M. Yamashiro, 2006, "Effectiveness of Credit Guarantees in the Japanese Loan Market," RIETI Discussion Paper, 06-E-004.
- Because not many exiting companies were contained in the data used for our analysis, it is difficult to examine whether the use of a credit guarantee program significantly brought down the default ratio. Companies that used the special credit guarantee program are no exception to the mechanism of natural selection in which well-performing companies are to stay on and poor-performing companies exit from the market.
February 7, 2006
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