Financing Scotland's recovery: analysis

Part 1- Economic Overview

Introduction

The COVID health emergency is having an unprecedented impact on businesses across Scotland and this will have consequential economic and social costs in the years ahead. The remedy of UK Government loan schemes, facilitated by the banks, has temporarily deferred many of these consequences, but in time will bring new risks to the balance sheets and sustainability of Scottish businesses. Understanding and effectively managing these risks is critical to avoiding a “drag effect” on recovery, innovation, productivity and growth.

I am mindful that Ministers will be receiving regular updates on these matters from the SG’s Office of the Chief Economic Adviser (OCEA) and, for that reason, I have chosen to provide only an overview of the critical points which best contextualise my commentary and recommendations.

Critical Point 1: UK Government loan schemes have vastly increased the debt carried by Scottish businesses

Overview

Just over a third (35%) of businesses in Scotland applied for support from UK Government-backed loan schemes and 30% of businesses were successful in receiving funding^[2]. Businesses in Scotland secured around 6% of the volume of CBILS and BBLS loans, in line with Scotland’s share of the business base^[3].

Bounce Back Loan Scheme (BBLS)

BBLS provides up to six-year terms for loans of £2,000 up to 25% of turnover (capped at £50,000)^[4]. The UK Government provides lenders with a 100% guarantee against loss and, for borrowers, covers the first year of interest and fees. Borrowers do not require to make repayments for the first 12 months. The scheme is scheduled to close in March 2021, although firms in receipt of loans can now take advantage of more flexible repayment terms under the newly-announced ‘Pay As You Grow’ scheme.

Coronavirus Business Interruption Loan Scheme (CBILS)

CBILS provides loans and other finance facilities of up to £5 million. Loans can be repaid over six years. The UK Government provides lenders with an 80% guarantee against losses. No personal guarantees are taken for facilities under £250,000. Over £250,000, personal guarantees are at the discretion of the lender, but debt recoveries are capped at 20% of the outstanding balance. A Principal Private Residence cannot be taken as security to support a personal guarantee for a CBILS-backed facility. The scheme is scheduled to close in March 2021.

Data to January 2021 shows that 86,062 loans worth £2.5 billion have been offered across Scotland under BBLS. 4,144 loans worth £983 million have been offered across Scotland under CBILS^[5].

Critical Point 2: Demand for Finance is significant, but more than half of business borrowing remains unspent

Just under half of UK businesses surveyed in June 2020 anticipated needing more credit as a result of the pandemic, with the majority expecting the credit needed to be available^[6]. The proportion of UK businesses using finance has increased since the start of the pandemic, from 32% in 2020 Q1 to 44% in Q4^[7]. The banks report that SME borrowing has increased at an unprecedented rate of 21% compared with last year. Alongside this, there has been a fall in the proportion of UK SMEs defining themselves as ‘permanent non-borrowers’ (not currently using finance and having no inclination to do so) from 50% in 2020 Q1 to 32% in Q4^[8]. It indicates businesses’ increasing need and willingness to borrow to cope with the impacts of the pandemic. For many of these businesses, the pandemic is the first time that they have accessed term debt finance.

There has also been a rise in the proportion of UK SMEs injecting personal funds into the business with almost four in ten (38%) doing so in 2020 Q4, up from 24% in 2020 Q1 and in line with levels last seen in 2013^[9]. Demand for credit has softened since the initial surge in applications for Government-backed loans, with the latest data from the Bank of England indicating that demand for corporate lending from small and medium-sized businesses fell slightly in 2020 Q4 but increased for large businesses^[10]. Looking ahead, businesses’ demand for finance will depend, amongst other things, on the level of cash reserves held and how the pandemic develops, including the potential need for further restrictions and the related pace of recovery in the most impacted sectors.

The latest data shows that businesses’ cash reserves have actually increased during the pandemic^[11], likely due to the injection of funds from Government-backed loans and other Government support such as furlough. The extension of furlough and the loan scheme flexibilities announced as part of the Winter Economy Plan will mitigate the expected acceleration in the rate at which businesses will require to use up this capital. This will likely delay the anticipated economy-wide ‘cliff edge’ from the end of 2020 to the first half of 2021.

Critical Point 3: UK Government Loan Guarantees increased the Supply of Debt Finance

The supply of finance to UK businesses has increased considerably in the months following the onset of the COVID-19 pandemic, with businesses raising significant sums in loans, equity, bonds and commercial paper. Approximately 40% of finance to businesses has come from loans^[12].

Reflecting the significant uptake of UK Government-backed loans, the latest data for Scotland shows a spike in new loans to SMEs in 2020 Q2 followed by a smaller increase in Q3, driven by lending to small businesses^[13]. In the UK as a whole, the growth rate of net lending to UK businesses was at its highest point for over ten years in June 2020 (10.9%), with the latest data for December continuing to show strong growth (9.5%)^[14].

Following a significant improvement in credit availability for UK businesses in 2020 Q2 and a moderate improvement in Q3, overall availability was broadly unchanged in Q4, decreasing for small businesses and remaining unchanged for medium and large firms. Overall credit availability was not expected to change in 2021 Q1^[15]. The longer the impacts of the pandemic persist, the more likely it is that cash reserves will fall in the months to come, potentially triggering a second surge in demand for finance.

A new surge may be challenging; state backed schemes are scheduled to end in March and many businesses are already heavily debt leveraged, calling into question their onward viability. This makes the design of successor finance schemes, innovative use of equity and fair streamlined recovery processes, crucial. All of these issues are explored in detail in the proceeding sections of this advice.

Critical Point 4: Lack of affordability checks for BBLS presents future risk

Whilst debt taken on by businesses during the pandemic has been crucial in helping them to survive, it has raised concerns about ability to repay and the impacts on growth if cash flow is directed towards servicing debt at the expense of investment. It is estimated that between 35% and 60% of borrowers may default on BBLS loans^[16]. In 2020 Q3, around a fifth (21%) of UK SMEs were concerned about their ability to repay finance over the next 12 months^[17]. Half (51%) of UK company directors surveyed in May 2020 said that debt taken on during the crisis would have a negative impact on their recovery^[18].

This analysis perhaps reflects the fact that no assessment of viability or loan affordability was undertaken as part of the BBLS process; making it difficult to model the future performance of businesses. This will present challenges to both borrowers and commercial lenders when assessing the affordability of additional finance.

Critical Point 5: Beyond the Emergency we face Economic ‘Long-COVID’

There is emerging evidence that businesses are likely to experience what might be described as ‘economic long-COVID’. Even as the public health crisis eases, the challenges affecting the economy will persist over the medium to long-term, with compounding impacts on businesses and households. The latest Office for Budget Responsibility (OBR) forecasts indicate, in the central scenario, a very gradual recovery in economic activity where real GDP does not return to pre-COVID levels until 2023 (see Chart 1)^[19]. The OBR also forecasts unemployment peaking in Q2 of 2021 and only returning close to pre-COVID levels in 2024. In short, the pandemic and its economic impact may weigh down businesses for years to come.

Source: Office for Budget Responsibility, November 2020, ‘Economic and Fiscal Outlook – November 2020’

Chart 1 is a time series line chart that shows OBR’s assumptions of real GDP paths for the UK over the period Q1 2018 to Q1 2026. The March forecast shows an increasing positive trend, whereas the real trend plummeted in early 2021. OBR’s upside scenario shows output recovering quickly beyond Q1 2021 and regaining the pre-virus peak by the end of 2021. The central forecast does not show a return to pre-virus peak until the end of 2022. The downside scenario shows output only returning to pre-virus peak by the end of 2024.

A further symptom of this economic long-COVID is its lasting impact on economic demand. Chart 2 from the latest OBR forecasts show that real private consumption and real business investment are likely to remain depressed below pre-pandemic levels for an extended period^[20].

Source: Office for Budget Responsibility, November 2020, ‘Economic and Fiscal Outlook – November 2020’.

Chart 2 is a time series line chart that shows OBR’s assumptions of real private consumption in the UK over the period Q1 2018 to Q1 2026. The March forecast shows an increasing positive trend, whereas the real trend plummeted in early 2021. Private consumption returns to its pre-virus peak by the middle of 2022 according to the OBR’s November forecast. This is a much stronger recovery than assumed in the FSR central scenario, where consumption had not recovered to its pre-virus peak by the forecast horizon.

The second line chart shown in chart 2 shows OBR’s assumptions of real business investment over the period Q1 2018 to Q1 2026. The March forecast shows an increasing, slight positive trend, whereas the real trend plummeted in early 2021. Business investment regains its pre-virus peak by mid-2023 according to the FSR central scenario. A slower recovery is shown by the November forecast where business investment doesn’t reach its pre-virus peak until the beginning of 2025.

There will, however, be variability in the extent to which different parts of the economy will experience this phenomenon. The sectors that have been most exposed to COVID impact are most likely to emerge from the pandemic considerably weaker, impacting on their pace of recovery and resilience to further shocks in the recovery phase. OCEA’s assesment of sectors by COVID exposure (See Table 1) suggests the following sectors are likely to be most exposed to the risk of ‘long-COVID’ depending on impact channel:

• International Demand: agriculture, forestry and fishing; mining and quarrying industries (largely oil and gas); and, parts of manufacturing.
• Domestic Demand: accommodation and food services; administrative and support services; arts entertainment and recreation; and, other services.
• International Supply: manufacturing; and, accommodation and food services.
• Labour Market Disruption: retail and wholesale; and accommodation and food services.

Table 1: OCEA Assessment of Sectoral Exposure to COVID-19 Impact Channels

Sector of Economy	International Supply	International Demand	Domestic Demand	Labour Market Disruption
Agriculture, Forestry and Fishing	Amber ↑	Red ↑	Yellow ↔	Yellow ↔
Mining and Quarrying Industries	Amber ↑	Red ↑	Amber ↔	Yellow ↔
Manufacturing	Red ↔	Red ↔	Amber ↔	Amber ↓
Electricity & Gas Supply	Yellow ↔	Yellow ↔	Yellow ↔	Yellow ↓
Water Supply & Waste Management	Amber ↑	Yellow ↔	Yellow ↔	Amber ↑
Construction	Amber ↑	Amber ↑	Amber ↓	Yellow ↓
Retail & Wholesale	Amber ↑	Amber ↑	Amber ↓	Red ↔
Transport & Storage	Amber ↑	Amber ↑	Amber ↔	Amber ↔
Accommodation & Food Services	Red ↑	Amber ↔	Red ↔	Red ↔
Information & Communication	Amber ↔	Amber ↑	Amber ↑	Yellow ↔
Financial & Insurance Activities	Amber ↑	Amber ↑	Yellow ↔	Amber ↔
Real Estate Activities	Yellow ↔	Amber ↑	Yellow ↔	Yellow ↓
Professional, Scientific & Technical Services	Amber ↑	Amber ↔	Amber ↑	Yellow ↓
Administrative & Support Services	Amber ↑	Amber ↑	Red ↑	Amber ↓
Public Administration and Defence	Yellow ↓	Yellow ↔	Yellow ↔	Amber ↓
Education	Yellow ↔	Amber ↔	Amber ↑	Amber ↓
Health and Social Work	Yellow ↓	Yellow ↔	Amber ↑	Red ↔
Arts, Entertainment and Recreation	Yellow ↔	Yellow ↔	Red ↔	Yellow ↓
Other Services	Yellow ↔	Yellow ↔	Red ↑	Amber ↓

Key

Yellow = Lowest Risk Rating

Amber = Medium Risk Rating

Red = Highest Risk Rating

Arrows show change since April's assessment

↑ shows where a sector is upgraded to higher rating

↓ shows where a sector is downgraded to lower rating

↔ shows where a sector's rating is unchanged

Source: Office of the Chief Economic Adviser, Scottish Government (assessment as at October 2020)

The ONS Business Impact of Coronavirus Survey (BICS) indicators suggests that the sectors which are most exposed to these COVID impact channels are among the main that have been most weakened by the pandemic.

For example, over the period 5 – 18 October 2020, the sectors reporting high to moderate risk of insolvency include: accommodation and food services (36%); transport and storage (29%); manufacturing (20%); administration and support services (16%); arts, entertainment and recreation (at least 12%) and construction (10%)^[21].

Further, the ONS BICS survey shows that over the pandemic period, investment across all sectors of the economy has been depressed. A third (33%) of businesses in Scotland report that capital expenditure has been lower than normal or stopped entirely as a result of the pandemic. This trend is more pronounced among larger businesses (250+ employees) than small enterprises^[22].

While reduced capital expenditure may represent general uncertainty in the business environment, it may also be a result of businesses pivoting their resources to surviving the impacts of the pandemic, instead of longer-term investment.

In summary, the evidence shows that many businesses, especially in sectors most impacted by the pandemic:

• will struggle to immediately generate sufficient cash to start making repayments against loans they have taken as a result of the distress caused by the pandemic;
• will emerge from the pandemic in a weakened state and may require access to additional finance to rebuild and to weather the period of gradual recovery until they return to conditions close to business as usual;
• will be forced to direct funds towards debt repayment at the expense of investment in growth, productivity, jobs and wages;
• will be in a weakened state to cope with any further disruptions to the business environment, either by the pandemic or EU exit, and will be reliant on the State and the financial sector for support to deal with any further negative shocks.

The analysis reinforces the need to ensure that debt repayments are manageable and can co-exist with access to capital for investment in growth. It also signals the possible need for Government initiatives to shift from universal support towards targeted support for the most distressed sectors and communities.

Critical Point 6: EU Exit will compound these impacts

The UK’s departure from the EU will amplify these challenges and could extend them to sectors that may otherwise have coped relatively well with the pandemic.

The OBR’s baseline scenario estimates that under a Free-Trade Agreement (FTA) UK GDP will be around 4% lower in the long run compared to continued EU membership^[23].

The Bank of England has updated its assessment now that the Trade and Cooperation Agreement has been agreed, concluding that additional barriers to trade will result in trade between the UK and EU being lower than it otherwise would have been under continued Single Market membership. This in turn is expected to reduce investment, productivity and GDP. GDP is projected to be around 3.25% lower in the long run due to lower trade with the EU^[24].

Immediate and short-term effects of leaving the Single Market include the introduction of non-tariff barriers to trade with the EU, increased disruption to supply chains already experiencing challenges due to COVID-19, and heightened uncertainty in some markets. These barriers are concentrated in areas of manufacturing, food and drink, agriculture and fisheries.

These sectors most exposed to increases in trade costs with the EU have largely been relatively less impacted by COVID. Over the longer term, productivity impacts and lower migration arising from leaving the EU become more important drivers of growth forgone, with implications for all sectors of the economy relative to remaining in the EU Single Market.