Who gets first knocked out in a recession?

I    Introduction

The question addressed here is, whether it is the small-scale unit or the large-scale unit that goes out of the market first, when economy is embroiled in a recessionary spiral. The paper explores the history of business failure in India to find some evidence on the same.

 

It is commonly perceived that big firms have much more resilience and resistance to adverse market conditions compared to small scale units because of their economies of scale, high profit margins and accumulated reserves. However, the year 2008 seems to be an year of "fall of giants". The melting heat was first experienced by the developed countries. The big names in financial sector like AIG- the largest insurer, Lehman- the biggest investment banker, Wa Mu - US's largest saving and loan bank were the first to bite the dust with the onset of sub-prime crisis. In the manufacturing sector, the auto giants who account for 4% of the GDP of US like GM and Chrysler are coming close to bankruptcy. The firms which had started laying-off people massively are not the small ones but big firms like the mining giant Anglo American, Rio Tinto, IT tycoon Microsoft etc. The media industry, which survived on advertisement revenues, opened their roll with New York Times and Tribunal.

 

II     What does the theory say?

There are several factors like managerial inefficiency, competitive forces, entry deterrence strategies of rivals, macro economic pressures, policy measures of government etc. which could be put together to explain business failure. In this paper, we limit ourselves to the "size" aspect of failure putting it against a recessionary background.

The organisational ecology theories (the underlying analogy is that firms are like organisms starting their life small, then mature, produce offspring and eventually die) focus on the age and size aspects of business failures and their interrelationships. One such hypothesis in the organisational ecology- 'liability of smallness' (small firms tend to exit fast) as
propounded by Aldrich and Auster (1986) emerges from lack of sufficient financial resources, managerial weakness, limited access to information and operational weaknesses like inadequate capacity utilization, inability to change according to market conditions and so on. Since organizations start small, it is difficult to disentangle the influence of newness and smallness. In fact youth and smallness are the greatest liabilities for the organization. There are many studies showing that it is the newness rather than the smallness that make small firms more prone to sickness. According to the available literature, evidences exist in both directions. Some studies put small firms superior to large firms and some others, vice versa.

Towards mid 1980's the concept of declining industries came up, where the important competitive move is disinvestments rather than investment, as happens during a recession or in the case of a technologically obsolete product. When exit becomes imperative, the firms should reduce capacity to remain profitable. But, capacity reduction is a public good, which should be provided privately by any of the existing firms. Hence, each firm would like its competitor to shoulder the reduction and the real question is who gives in first. This timing game in a declining industry is therefore a war of attrition rather than a race to pre-empt. Ghemawat and Nalebuff (1985) pointed out that in declining industry with a duopoly setup where exit becomes an all or nothing situation, the smaller of the two equally efficient duopolists will force its larger rival to exit as soon as duopoly profits turned negative. This was under the assumption that firms are perfectly informed about their competitors' costs and capacity and re-entry after exit is not allowed. If one relax the assumption of complete information, thus efficiency, and provide for uncertainty about rivals' costs, then there will be sequential equilibrium in the duopoly. When the expectations are symmetric, if exit occurs it will be the less efficient firm that leaves. Londregan (1989) allowing for re-entry and under the assumption of positive re-entry costs concluded that smallness would be an advantage during the decline and by backward induction during the growth phase.

Towards the end of 1980's the studies on multi-plant firms came up to provide for the adjustments in capacity during a declining phase. Whinston (1987) argued that it is difficult to reach any general conclusions regarding plant closures if capacity is adjustable only in lumpsum. In a later article (1988) he argued that when firms have different sized plants, multiple equilibria are possible, i.e. the largest firm will not necessarily be the first to exit or cut capacity. Ghemawat and Nalebuff (1990) gave firms greater strategic flexibility by letting them continuously adjusts their capacities as demand decreases. They found that large firms would first reduce capacity; continues so until they have shrunk to the size of their formerly smaller rivals; then all competitors with identical capacities reduce together. Under the assumption that firms are capable of incremental reduction in capacity, Leiberman M.B (1990) brought out two sets of predictions. If larger firms are more efficient and have economies of scale then such differences would cause smaller producers to be shaken out relatively early during a declining phase. In the absence of this cost difference, smaller firms would be profitable over longer periods as demand tapers off to zero. Given the superior ability of small firms to stake out, larger firms would rationally choose to exit early or would mimic their smaller rivals by drastically cutting capacity. In all these literatures, the relatively superior staying power of the small firms is emphasized. Stretching this concept of declining industry to a recessionary period when players appears to be too many, then one can probably say that the rate at which small firms exit from the market will be lower than the rate at which large firms leave the market during the depression phase of the economy.

During a recessionary phase hideout problems and Common Pool Problems
as propounded by Brigham et al. (1999) can accentuate the failure of firms by offering credible threats to restructuring and reorganization, once the firm identifies a problem that can lead to failure. Hide out problem is the difficulty in getting all the parties involved, to agree to a voluntary and informal reorganization plan. Common Pool Problem is the aggressive tendency on the part of individual creditors to foreclose or attach the properties of a defaulting firm even though it is worth more as an ongoing concern. This is because the attachment by one creditor would always reduce the value of the assets, hence operating cash flow. As a result, the value of the remaining creditors' claims would decline. Even those creditors who understand the merits of keeping the firm alive would be forced to foreclose because the foreclosure by other creditors would reduce the payoffs to those who do not. These factors operate irrespective of whether a firm is small or big. The tempo of business failure builds up if the institutions financing industry are in shambles. Thus a deflation arising out of bank failures can increase the number of failed firms in an economy. A more highly leveraged firm will have a greater difficulty in withstanding deflation and banking crises. This is because when information is asymmetric, firms' cost of external funds will depend on their networth and the ability of the banking system to issue loans. Thus during a recession, there will be a disproportionate increase in the cost of financing for the credit-constrained firms (or one with an already high debt-equity ratio) and thus an increase in their likelihood of failure.

Richardson, Kane and Lobinger (1998) talk about how, the aggressive growth strategies followed by firms can be detrimental to their existence during a recession. For these strategies to be successful, two conditions are to be fulfilled;

• The company should be able to sell its products at a price which exceeds the cost of investment the firm has made to increase the output and volume
  
• The demand for company's goods and services must be sufficient to absorb the output prices that maintain a positive net present value of the new investment made.
  

Both these factors typically weaken following a peak in the business cycle because prices and aggregate market supply declines as demand dwindles. This will reduce profitability and cash flows. Hence, liquidity from both, operating cash flows and available financial cash flows declines resulting in increased recession-induced default risk.

III     Evidence from India

In India, the concept of 'business failure' itself is alien as we uniquely termed it as 'industrial sickness'. In the 1980's enterprises never died though they failed; they were only allowed to remain "sick". Apart from there being many hurdles for entry, exit was also prohibited in order to protect labour-interests, exhibiting a phobia towards the closure of even the most inefficient units. This made India the unique abode of industrial sickness, where firms that must have otherwise been thrown out of the market, continued there with government support. Now with the proposed winding up of BIFR and introduction of SARFAESI Act market forces operate to a great extent in the exit or winding up of firms, such that the concept of "business failure" truly fits in.

 

The last recessionary phase of 1997-2003 wherein firms were more or less open to market forces with respect to their survival or exit is used as a reference period for analysing the shakeout pattern in the Indian scenario. For providing a background, the shakeout pattern in the previous period of industrial sickness 1983-92 is also given.

 

Average Annual Growth Rate of sick SSI units and sick/weak non-SSI units financed by scheduled commercial banks
Year	Sick SSI		Sick Non-SSI		non SSI units including weak units		Total including weak units
(End-March)	Units	Real Amount O/S	Units	Real Amount O/S	Units	Real Amount O/S	Units	Real Amount O/S
1983-92	16.80%	10.59%	14.06%	5.22%	3.88%	7.66%	16.55%	8.28%
1997-2003	-4.40%	1.06%	6.50%	9.15%	5.38%	11.86%	-4.29%	9.58%

 

Few interesting observations are:

1. Compared to the protectionist regime of 1983-92, business shakeout was far less in the post liberalisation period, contrary to the general perception that liberalisation has forced many industrial units out of business.
   
2. However, the real amount outstanding in these units have increased in the post liberalisation phase indicating the increasing capital intensity of firms
   
3. The most protected small scale sector witnessed massive failures during the period 1983-92 and not during the liberalisation phase. In fact during 1983-92, SSI sickness was higher than non-SSI sector sickness. (When SSI sickness was growing in the range of 17% per annum, non-SSI sickness was only 14% per annum.)
   
4. On the other hand, when the brutal forces of market was crushing demand down during the 1997 recession, average annual growth rate in the number of sick SSI units was coming down by around 4% whereas there was a build up of sickness in the non-SSI sector by around 7% per annum.
   
5. Compared to the 1983-92 period, non-SSI sector sickness has increased in the liberalised phase. The shakeout during the recession of 1997-2003 was stronger than that happened out of the flawed policy regime of 1980s which created high cost enterprises in the economy.
   
6. Looking closely at the yearly movements in the number of sick units, we realise that our large and medium scale units are vulnerable to external imbalances and sudden policy shifts much more than the small scale units. When Rajive Gandhi's government attempted moderate dozes of liberalisation, the effect was immediately visible in the trend of non-SSI sickness which tripled (SSI sickness doubled for the same year 1987). Similarly when recession hit the economy in 1997, the first set of industries to feel the impact appears to be in the non-SSI sector. (See Figure) By March 1998, sick non-SSI units grew by 4.2% whereas sick SSI units continued its decline (-5.7% per annum). However there was a sharp increase by 38% in March 1999 with respect to SSI sickness. This might be due to the slightly upward revision in the definition of SSI units (which have taken effect during 1998-99) as those units with Rs. 300 lakhs investment in plant and machinery instead of Rs. 60 lakhs as defined earlier. (In 1999, the definition of SSI was reverted to Rs. 100 lakhs investment in plant and machinery; See endnotes for definition of SSI's over time) It is not to say that recession did not have any impact on sickness in the SSI sector. In all likelihood, as theories on declining industries suggest, there seems to be a delay of one year for the small scale sector to get impacted.
   

   
   

   This time lag can be attributed to the flexibility and superior staying power of small industries in a depression phase. Many studies by SIDO and NCAER have shown that the technological advancement has made the SSI's more efficient in the post liberalisation period thus reducing their failure rate. In other words, technology is compensating for the disadvantages associated with small size. In recessionary years, their smallness itself is shown to be a blessing in disguise, especially when they are technically efficient.
   

   
    

   1. Another, interesting feature of the shakeout pattern in India is that the post-reform period is marked by a drastic reduction in the viability of sick units which indicates that chances are high for the practise of creative accounting among those who have fallen sick. In the year 1990 the outstanding credit that could be redeemed was 39% of the total amount blocked. In 2001, the amount that can be redeemed from the potentially viable units reduces to less than half of it- 17%. This has to be read along with the reduction in the percentage of weak units, which fell from 71% in 1980 to 12% in 2003. The dual classification of non-SSI sickness –Sick and Weak units- was supposed to take care of the early detection of sickness. However, the disgracefulness of 'weak status' force firms to cover their sickness and go for creative accounting, where losses and networth erosion appears only when it becomes impossible to hide it. This is substantiated by the fact that many of the annual reports do not show losses even when the firms are defaulters to their creditors. This is an after-effect of the common pool problem discussed above. Given that failure has a history, it is highly unlikely that firms fall sick on one fine morning. Stories of Satyam and other such corporate scandals points to this effect.
      

 

IV    Conclusion

It appears that the non-SSI sector in India is more vulnerable to recession than the small scale sector. In the present recession also, our small scale sector might be much more resilient due to its superior staying power in a declining phase. Perhaps government intervention is required in terms of avoiding the hide-out problem and common pool problem, such that effective restructuring and reorganisation of failed units is possible. This is particularly needed in a recessionary phase consequent upon bank failures. There is also a felt need for strengthening the capital structure of Indian firms (reducing the debt –equity ratio) in such a way that equity financing gives firms the superior staying power in a period of credit squeeze. Hence arises, the need to strengthen and deepen the stock markets which reduces the cost of capital (ownership) to Indian firms.