Yves here. This article warns that Covid shock increased debt levels in the corporate sector. It also says much of this debt should be reorganized. However, sometimes basically sound companies borrow too much. They can still wind up on a path of underinvestment and staff cutting that hurts competitiveness, witness Toys ‘R’ Us. Companies that go bankrupt can go bankrupt again due to the restructuring not discharging enough debt. Successive bankruptcies are also paths to hollowing out of companies.
In other words, the distinction between “good companies that borrowed too much” and “not so hot companies that borrowed too much trying to make a dubious business model work” is not as clear as this article seems to assume. And workouts of “good companies” don’t always have happy outcomes, particularly for their employees. Nevertheless, restructuring sooner rather than later is much more likely to prevent poor outcomes than hopium.
By Moritz Schularick, Professor of Economics, University of Bonn; Research Department, Federal Reserve Bank of New York. Originally published at the Institute of New Economic Thinking website
In the decade after the global financial crisis, in a time of low-interest rates, businesses in many countries have leveraged up. Time-tested indicators of exuberance in corporate lending markets such as the share of high yield bond issuance, covenant-lite lending, and issuance of collateralized loan obligations (CLOs) were all flashing red at some point in recent years. While quantities of credit were rising fast, the price of corporate credit risk in financial markets fell substantially. Lower credit spreads despite higher volumes and lighter covenants signaled to many that a corporate credit boom had taken hold which could end badly and make a future downturn much more severe (Yellen 2019).
This was the picture before the Covid pandemic. The economic fall-out of the pandemic has exacerbated the situation in two ways. First, corporate earnings have temporarily collapsed in most industries, lowering debt service capacity. Moreover, accelerated structural change in the aftermath of the pandemic could mean that some sectors or business models are permanently impaired. Second, to bridge the revenue shortfall government facilities have been set up during the pandemic that have offered liquidity at favorable terms. They increased corporate liabilities even further. In the year 2020 alone, corporate debt to GDP levels surged by about 15pp in emerging markets and by about 10pp in advanced economies.
In our new INET Working Paper, we try to peer into the future by looking back at the past. We study past corporate credit booms and their after-effects. We ask: how severe will the aftermath of the corporate debt surge be? Do we have to dial down expectations for a swift recovery as corporate debt overhang becomes a millstone around the neck of the economy?
Two historical analogies are often invoked to highlight the risks that debt overhang could pose for the recovery. The first reference point is the experience after the global financial crisis that highlighted the role of household debt and balance sheet repair for aggregate spending. The second example is the Japanese experience in the 1990s. When the Japanese financial bubble burst, corporates were left with significant debt on their balance sheets. The debt overhang, slow restructuring of bad debts, and ongoing lending to “zombie” companies are seen as important reasons behind the prolonged recession and depressed productivity growth in Japan’s lost decades.
However, when studying the entire history of corporate credit booms in advanced economies since 1870, we find that the economic fall-out from corporate credit booms tends to be small. Unlike household credit booms, the aftermath of corporate debt cycles is not systematically associated with subpar macroeconomic performance. In the history of modern business cycles, more corporate credit-intensive expansion phases are not followed by deeper recessions and slower recoveries.
Yet there are three important caveats to this Panglossian view of corporate debt booms and their aftermath. First, not all corporate credit booms are alike. The composition of the corporate debt boom matters, as recent research has shown. Non-tradable debt is associated with macroeconomic boom and bust dynamics akin to household debt booms. Second, debt reorganization and bankruptcy codes must function reasonably smoothly and encourage swift and efficient reorganization of corporate balance sheets. If liquidation or reorganization is slow and costly, the macro-effects of corporate debt overhang become measurable and sizeable.
The third caveat relates to the origination side of corporate debt. In particular, in bank-based financial systems the risk exists that weakly capitalized or weakly supervised banks have incentives to avoid losses and evergreen bad loans in the hope of a future recovery of asset values or an improvement in the financial position of the borrower. “Extend and pretend” policies leading to “zombie lending” were arguably a major impediment to Japan’s recovery from the crisis in the 1990s.
Yet in the current situation, all three caveats only apply to a limited extent. The sectoral composition of credit in the past decade was not particularly heavy in the non-tradable sector. Progress has been made to align and accelerate corporate debt reorganization, and banking supervision and its enforcement are generally much more stringent today than in 1990s Japan.
Indebtedness and debt overhang problems in the corporate sector are often conjured as key risks for a quick rebound from the pandemic. However, recent insights from macro-financial research do not raise alarm bells. The literature makes a clear distinction between the aftermath of household credit booms – which tend to be costly – and corporate credit booms that are not systematically associated with subpar economic outcomes.
The main policy implications stemming from the history of corporate debt cycles are reasonably clear. Default rates will likely rise and not all business models have a future. In such an environment, there is nothing to fear but a policy of kicking the can down the road. Swift reorganization or liquidation of insolvent businesses is the single best policy to deal with corporate debt booms.
Couple of thought exercises, to counter some points made in the above.
1. Composition of credit in non-trading sectors. I have an opinion, perhaps ill-advised, that the increase of the shadow banks / non-bank lenders is a component, the possibly this article overlooks. Firms that began before the Great Recession, and possibly had some boom years after the bust were able to expand.
2. Corporate earnings may have ceased to be in collapse mode. I don’t readily have quick proof, but for every INTC that issues a bad report / forecast, there are more alike to AMD, Nvidia and so on. The intervention by the FED / Treasury certainly helped corporate debt issuance, without a doubt.
Back in 2014-2015, a senior level banker and capital markets trader in DFW commented (to me) we were trending towards Japan. May have been his gut or his instinct.
Off topic, but I’m wondering how they efficiently restructure all that debt so that the corporations are sustainable going forward – not sustainable economically in the old sense of free-market profitability, but sustainable in the climate-change sense. Because the situation we are in could be a good thing, as Martha says. Does Martha still say that? Restructuring to meet the future.
Spoken like a true Professor of Economics…everything but ceteris paribus. Here we have an economy in which almost every sector is monopolized. Damn little actual capital investment in innovation, productivity or new products. So, what are they doing with all of the cash proceeds from this debt? From what I can see (other than buying their very last competitor) the fashion of the corporate world remains in buying equity to increase stock prices and reward corporate insiders with various kinds of bonuses…a twofer. And the resulting debt? In the words of Paul Krugman, meh! Our professor would have served us all a bit better if he had followed the free money and exposed what is actually legalized control fraud. Yes…zombies…all blessed in the eyes of the Federal Boutique Bespoke Bank (FBBB). These guys never follow the money.
I wanna hear from that FBBB staffer who in the recent Footnote 3 called capitalism a criminal enterprise. Do you suppose he remains at his desk?