China’s economy plunged in January and February of 2020 for the first time in many decades, with a 13.5% contraction of manufacturing output. As other countries move into lockdown, it seems increasingly plausible that the coronavirus crisis will not only trigger a steep contraction but also a protracted one, as public-health policies backload the time when the peak of the epidemiological curve will be reached. Financial markets the world over point to severe economic impact. Travel, hospitality, leisure, and some manufacturing firms have already experienced considerable revenue deterioration, other sectors are likely to follow. Governments are putting ambitious support programs in place for both households and firms.
Many countries, including Germany, France, Sweden and Denmark, are extending unemployment and short-time work benefits and the US is considering direct transfers to households. Emmanuel Macron has announced that “no company, whatever its size, will have to face the risk of bankruptcy”. Other countries act similarly. Policy responses outlined so far largely aim to be broad and fast (“keeping the lights on”). Germany has announced “unlimited” loan support via KfW, its public development bank, France and Spain are offering loan guarantees of up to €300bn and €100bn for companies, respectively, and Italy and others are also putting in place massive business-support programs. Several countries plan to offer tax deferral programs. Central banks use various policies to encourage banks to lend to affected firms, by releasing countercyclical capital buffers or extended facilities to purchase government and corporate debt.
Much of the hundreds of billions of emergency aid packages for companies will come in the form of credit or credit guarantees. This makes sense for two reasons. First, many sovereigns go into this crisis with high levels of government debt, largely due to policies adopted in response to the 2008 global financial crisis (GFC). Sovereign spreads in the Eurozone, for Italy in particular, are already widening, indicating that there could be more trouble ahead for the credibility and solvency of sovereign borrowers. Sovereigns now need to preserve their fiscal resources, and gifts are more demanding than loans and guarantees. Second, the economic effects of Covid-19 are likely to be very heterogeneous across sectors,
and there is little time to sort out exactly how. In short, the heterogeneous impact of the health crisis and lockdowns, large uncertainty about the course of the health crisis, the need to use sovereign resources wisely, and a great urgency to respond, all favor using credit to support the private sector. However, the Covid-19 crisis arrives against a backdrop of private-sector indebtedness. Corporate and household balance sheets in Europe are extended – neither firms norhouseholds deleveraged substantially since the GFC and the European sovereign debt crisis; on the contrary, low monetary policy rates and low credit spreads lured them into complacency about debt levels. Corporate leverage is at an all-time high. A large fraction of corporate debt is now rated BBB, the lowest investment grade rating, and more than ever is rated below investment grade – for example, almost half of all US corporate bonds maturing in the next five years are below investment grade.
Current policies will inevitably leave parts of the corporate sector with even larger debt burdens. These will delay a recovery: distressed firms tend to implement labor reductions, sell assets, reduce investments and employment, and shrink their business, and they become reluctant to raise new capital. Additionally, banks and other lenders stuck with underperforming loans may restrain lending and misdirect it to “zombie firms”. If one firm is affected, its customers, suppliers and employees are affected in turn. All of this can turn a temporary economic shock into a long-term balance-sheet driven dislocation. One policy lesson of the big financial crises in the developed world, starting with Japan in the early 1990s, is that the effects of simmering corporate debt overhang are multiple and nefarious. To manage the looming corporate debt strains and keeping the likely precarious situation of sovereign finances in mind, we see three broad policy areas that require addressing.
First, public credit packages such as loan-guarantee programs should be designed with the looming debt-overhang problem and the future need for debt restructuring in mind. Conflicts of interest become important when companies have multiple creditors, and bailouts create new creditors, making restructuring more complicated, as the bank bailouts after the GFC demonstrated. Programs must also ensure that bailout funds are used as intended: to ensure business continuity, and not to benefit existing debt holders or shareholders. Policy should also have an eye to future crises. Unlike the bank bailouts after the GFC, bank risk-taking did not trigger the Covid-19 crisis and this means moral hazard concerns are weaker. They are not absent, however, since banks may use current policy choices to infer the level of taxpayer support that will be available in other types of crisis. Therefore, bailouts should be designed to avoid benefitting existing creditors and shareholders, when possible. Given all these concerns, bailouts should contain provisions that limit the scope to which investors benefit from support.
We recommend banning dividend payments and most debt reductions for all recipients of support. We also recommend that any taxpayer-funded credits be senior in the event of future restructurings. It may also make sense to attach options to the bailout funds in the form of stock warrants or convertibles that can ensure that the public benefits from future gains in corporate valuations made possible by public money, especially for publicly listed companies.
Insolvency proceedings in court
Second, European systems for handling insolvency in court are not good at protecting viable businesses with unsustainable capital structures. Businesses are too often liquidated, generating poor returns for bankruptcy claims, and processes can be slow. These inefficient incourt proceedings hold back credit-market development even in good times. In a recession or crisis, it slows down returning productive assets to the economy and may destroy valuable businesses. Any reforms that can simplify and speed up in-court processes should be considered. Such reforms would need to be exceptionally quick to impact short-run developments, but they can help support a vigorous recovery. Current European Union initiatives for better resolution of corporate insolvency should be accelerated.
Third, given the inefficiencies of court-supervised bankruptcy procedures, government agencies must be prepared to be a leader in debt restructuring for the companies that are bailed out. They should prioritize out-of-court renegotiations whenever possible. They have proven a successful tool after the GFC. This can include temporary nationalizations where needed, with tough conditions for existing shareholders to avoid distortions. Public agencies such as public
development banks in charge of loan guarantees may not be the best placed to oversee debt restructuring – with their own balance sheets exposed, they may be inclined to “extend-and-pretend” distortions in their actions. So it is worth thinking about an independent organization of government leadership in debt restructuring.
TSE Mag #20: Spring 2020