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Manufacturing Bonds

Presenting a Bond Guarantee Program that Could Help Our Small Manufacturing Companies Survive and Hire

SOURCE: AP/Amy Sancetta

Vice President Joe Biden tours Wrap-Tite, Inc., a stretch-wrap manufacturing company which landed a $1.5 million Small Business Administration loan in 2011. With Biden are Wrap-Tite, Inc. CEO Suresh Bafna, rear, and President Sunil Daga.

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Manufacturing remains an integral part of our economy. Manufacturing companies provide well-paying, middle-income jobs. U.S. manufacturing wages are, on average, 19.3 percent higher than the private-sector average even though the sector employs an above-average share of those without a college education. Manufacturing also drives innovation. Manufacturing companies account for more than half of all public and private research and development in the United States, the benefits of which spill over into other sectors.

While U.S. manufacturing today suffers from lower employment levels and slower growth in output than in the past, the sector is by no means a lost cause. Much can be done to bolster its competitiveness. For one, the federal government can help create jobs and increase output by improving the performance of manufacturers by increasing their access to capital.

Small manufacturers today cannot easily access financing to restructure, grow, and scale up their businesses. Low-priced bank loans and lines of credit are more difficult to obtain for small- and medium-sized manufacturers, the pool of venture capital is smaller than it was years ago for startup advanced manufacturing companies, and access to bond markets can carry high borrowing and transaction costs due to the small size of many manufacturing companies.

Without sufficient working capital, small- and medium-sized manufacturers may not be able to grow, which is bad for the economy and bad for job creation. As one part of a broader strategy to strengthen the manufacturing sector, we believe policymakers should explore the idea of creating a manufacturing bond guarantee program. This program would be available for those firms that participate in a revamped Manufacturing Extension Partnership program, which is run by the Department of Commerce’s National Institute of Standards and Technology.

This approach could be an inexpensive way to address both the financing gap and the jobs shortage in our economy, providing much-needed access to low-cost capital for small manufacturers to grow while allowing them to become more productive, innovative, and competitive by adopting best practices through the Manufacturing Extension Partnership. This issue brief details our proposal.

The productivity challenge for small manufacturers

Throughout the past decade, manufacturing output grew more slowly than the economy as a whole. Manufacturing’s contribution to gross domestic product—the largest measure of growth in our economy—fell to 11 percent from more than 14 percent between 1980 and 2010. Employment in the manufacturing sector also fell particularly hard in the past decade, as the sector as a whole lost approximately one-third of its jobs.

It would be wrong to assert that the reason manufacturing jobs are leaving the United States is solely because of low-cost labor overseas. Countries such as Germany have vibrant manufacturing sectors that produce a trade surplus despite offering wages that, on average, are among the highest in the world. There are many reasons for the success of German manufacturing, but the continued adoption of innovative practices and the training and hiring of skilled and well-paid workers has been critical.

The recipe for success in German manufacturing actually makes sense. Firms that are more productive and innovative are able to invest in new equipment and training, as well as pay their workers good wages. And firms with higher-paid and more-skilled workers have higher employee retention rates, which increases productivity for the company as more experienced employees are less prone to avoid making mistakes.

Similarly, the future success of the American manufacturing sector will depend on productivity increases that allow for the creation of well-paying jobs. Indeed, the United States already has manufacturing companies that are very productive and offer high wages to their employees. Yet the number of such companies is too few.

For many small- and medium-sized manufacturing firms, it is very difficult and costly to make the kind of investments necessary to develop new products, increase productivity, and hire new employees. Operational improvements might require multiple changes, which together can be costly for small manufacturers. As Susan Helper, an economist at Case Western University, notes:

Changing to a new production paradigm is particularly expensive and difficult if changes are complementary, that is, if two modifications made together yield greater performance gains than the sum of the two modifications made separately.

The end result is that many low-productivity, small manufacturing firms adopt a strategy of cutting costs by keeping wages down. Clearly the market is not always providing the right incentives for small manufacturing firms to make efficient decisions that are actually to their long-term benefit.

Why small manufacturers need capital and lack access today

Manufacturing companies, by their very nature, require more working capital than firms in other industries. The reason for this is that it takes manufacturers a long time to convert their resources and investments into cash flow through sales. This means that manufacturing firms have much of their money tied up in inventory and other parts of their business for a long period of time before it generates a return. For this reason, manufacturing firms often require more working capital than do firms in other industries.

The need for financing is particularly acute for small manufacturers at the beginning of the supply chain because they tend to operate at the behest of large, secondary manufacturers. Due to “just in time” supply chain strategies, large, secondary manufacturers who exert greater control over the supply chain require that smaller, primary manufacturers bear the costs associated with storing their inventory until the secondary manufacturer requests them. This reduces costs for larger manufacturers but results in an even longer cash-conversion cycle for smaller, primary manufacturers.

The most common form of capital for small manufacturers is debt, such as a line of credit or a fixed-term bank loan. Traditionally, manufacturers use real estate, business equipment, inventory, and receivables as collateral to obtain financing. The problem is that both commercial and residential real estate remain weak, and prices have yet to stabilize since the bursting of the housing bubble in 2008. Couple this problem with the broader tightening of credit and the reluctance of banks to lend, and the result is many small manufacturing firms are having difficulty obtaining the necessary working capital.

While many manufacturers are holding back on their expansion plans because of the perceived lack of demand from consumers and businesses in the U.S. and global economy, there are manufacturers that would expand if they could. A 2010 white paper for the National Institute of Standards and Technology, which oversees the Manufacturing Extension Partnership, noted that:

Even manufacturers whose revenues, margins, profits, suppliers, and customers are unaffected by the downturn in the economy… have found it impossible to maintain their current borrowing base, let alone receive the financing needed to grow. These firms are being penalized by the devaluation of their property, plant, and equipment.

The point is that some manufacturers are ready to expand, restructure, and hire but lack the financing to do so.

What is the Manufacturing Extension Partnership?

The Manufacturing Extension Partnership is contained within the National Institute of Standards and Technology at the Department of Commerce. It comprises regional centers in all 50 states and Puerto Rico, and its primary purpose is to provide technical assistance to small- and medium-sized manufacturers to become more competitive and productive. These regional centers are not governmental offices. They are nonprofit, state, or local organizations that were selected as manufacturing extension centers through an open and competitive process. The centers can compete for federal funding, and nonfederal sources must cover at least 50 percent of each center’s capital and costs, which can be obtained through matched funds, fees for service provided, and contributions from companies.

Research suggests that the Manufacturing Extension Partnership achieves positive results. Ronald Jarmin of the U.S. Census Bureau found that participating firms’ productivity rose between 3.4 percent and 16 percent more between 1987 and 1992 compared to those firms that did not participate in the program. A similar study compared manufacturing firms that participated in an extension center in Pennsylvania to those that did not and found that $1 in state spending on the program generates an increase of $21 in gross state product and $1.24 in additional tax revenue.

Yet despite the positive impact of the program, only 6 percent of small manufacturers reported participating in a manufacturing extension center over a three-year period. Part of this problem appears to be due to reductions in federal funding of the Manufacturing Extension Partnership, which has caused some extension centers to target larger firms that require less of a subsidy to participate. Often, small firms could not afford the costs and did not have the organizational bandwidth to adopt a broad improvement plan recommended by an extension center.

For this reason, for our proposal to be most effective, it should be accompanied by an increase in federal funding specifically for comprehensive extension services provided to small manufacturing firms. After all, the federal government spends four times as much on the agricultural extension program as on the Manufacturing Extension Program, even though manufacturing comprises more than 10 times as great a share of the U.S. economy.

How the guarantee program might work

The federal government must assist small manufacturing firms in overcoming the dual challenges of underinvestment in human and physical capital and the lack of access to affordable financing to expand and create jobs. For this reason, we propose the creation of a manufacturing bond guarantee program for small manufacturers that participate in the Manufacturing Extension Partnership through a regional extension center. This program could be one part of a broader agenda to increase productivity and employment in the small manufacturing sector.

The bond guarantee process would work from the bottom up as follows. First, small manufacturers of fewer than 200 employees would apply at the Department of Commerce to participate in the Manufacturing Extension Partnership and to borrow using federally guaranteed “manufacturing bonds.” Commerce is the right agency to receive applications for participation in the program because it houses the Manufacturing Extension Partnership. To be able to participate, manufacturers must have a credible plan to grow their business and create well-paying jobs in the United States. All proceeds from bond issuances must be used to fund the restructuring, expansion, or scaling up of their business.

Second, the Small Business Administration would analyze the finances and debt-paying abilities of manufacturers that apply to the program. The importance of this assessment is that it will help reduce the risk of unexpected losses by ensuring that certain financial safety and soundness standards are met.

Third, conditional upon participation in the Manufacturing Extension Partnership, the small manufacturer draws down money in the form of a loan from a “manufacturing trust” housed within the Small Business Administration. The proceeds from this drawdown would be used by the small manufacturer as working capital and would be repaid to the trust over the life of the loan.

The Small Business Administration is the right agency to perform the due diligence and underwriting of the bonds because it has the experience and infrastructure to oversee a loan guarantee program. And clearly, this program would require that the Department of Commerce and the Small Business Administration interface with one another to ensure that information about participants is properly shared.

Fourth, the manufacturing trust would issue federally guaranteed manufacturing bonds to investors on behalf of this pool of small manufacturers. The manufacturing trust would advertise the bonds for sale, outlining the terms of the bond, and offer them in a bid auction process, with the bond going to the highest bidder. The proceeds from this bond issuance would fund the drawdowns by small manufacturers. The repayment of drawdowns by participating firms would be used to pay back the investors of the manufacturing bonds.

Fifth, the small manufacturer would pay a guarantee fee to a reserve fund to cover any expected losses from the federal guarantee. The size of a guarantee fee is based on risk assessment calculations. The total fees paid into the reserve by participating small manufacturers must be sufficient to compensate the government for the risk of guaranteeing the principal and interest payments on the bonds. Fee levels could vary on the basis of the assessed risk of participating manufacturers, though that is by no means necessary.

The benefits: Lower borrowing costs, job creation, and adoption of best practices

This type of program would provide affordable access to capital markets for small- and medium-sized manufacturers. Guaranteeing the debt of these firms lowers borrowing costs by improving the credit quality of the loans. With lower costs of capital, firms will be better positioned to restructure their operations to become more competitive, and would have the financing necessary to expand by creating well-paying jobs.

What’s more, by facilitating participation in the Manufacturing Extension Partnership, this program could assist firms in adopting best practices, improving their organizational plan, and better training workers to be more productive. And the kicker? This proposal is actually relatively inexpensive. Unlike a grant or a loan, which requires upfront money to award or lend to an institution, the cost of a loan guarantee is its expected loss, which can be offset by guarantee fees paid by participating small manufacturers.

Jordan Eizenga is an Economic Policy Analyst at the Center for American Progress. James Hairston is a Research Associate on the Economic Policy team at the Center.

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