Neeltje van Horen
Faced with unprecedented declines in corporate revenue, the Covid-19 shock represents a loss of cash flow of indeterminate duration for many firms. It is too early to tell how exactly firms will be affected by this crisis and how scarring it will be, but the crisis will likely have a significant impact on most corporates. This post reviews the literature on factors affecting firms’ ability to withstand the Covid-19 shock and what large corporates did to shore up their finances.
Corporate stock price reactions
The Covid-19 shock had a big impact on stock markets worldwide. Using a newspaper-based Equity Market Volatility (EMV) tracker Baker et al (2020) show that no previous infectious disease outbreak, including the Spanish Flu, has impacted the stock market as powerfully as the Covid-19 pandemic. However, there was substantial heterogeneity in stock market reactions which can give useful early insights, until such time as firm balance sheet data become available, to understand which type of firms are likely to be more at risk. Perhaps unsurprisingly, financial flexibility and the ease to shed costs when revenues decline were being rewarded by investors.
Ramelli and Wagner (2020) show that when the virus was still contained to China, investors tended to move out of internationally-oriented US firms, especially those with China exposure. As the virus spread to Europe and the US, corporate debt and cash holdings emerged as the most important value drivers. This remained true even after the Fed announced a series of measures to support the economy on 23 March.
Fahlenbrach, Rageth and Stulz (2020) find that US non-financial firms with lower cash holdings, higher short-term debt, and higher long-term debt experienced worse declines in stock returns and benefited more from the news about the Fed’s policy response. Interestingly, this paper also finds that the ex-ante ability of firms to access financial markets (based on popular measures of financial constraints) did not explain stock market returns. In other words, it is not the ability to access financial markets, but the actual need to access them that appears to matter. These findings are confirmed by Ding, Levine, Lie and Xie (2020) in a multi-country setting. In addition, this paper shows that the drop in stock market prices was milder among firms less dependent on global supply chains, with more corporate social responsibility activities and with less entrenched executives.
Alfaro, Chari, Greenland and Schott (2020) also study stock market response but take a different approach. They use simple epidemiological models of infectious disease to isolate unanticipated changes in the trajectory of the disease. They show that an unanticipated increase (decrease) in predicted infections forecasts negative (positive) next-day stock returns. These findings are consistent with investors using such models to update their beliefs about the economic consequences of the outbreak in real time, or these models being a good approximation of investors’ beliefs. Using the same variation in predicted infections the authors find that the Covid-19 related losses in market value are larger for more debt-laden, less profitable and more capital-intensive firms. The latter result suggests that investors value the relative ease with which labour versus capital costs can be shed.
How do firms shore up on liquidity?
Acharya and Steffen (2020) also confirm the importance of liquidity for a firm’s market valuation, but in addition provide some first insights as to how large US corporates attempted to shore up their liquidity. Credit line usage accelerated rather early during the crisis period and became somewhat flat by the end of March. While most firms were raising cash through credit line draw-downs, riskier firms were drawing down much larger amounts.
This is line with earlier findings from the global financial crisis that firms that had enough internal funds choose not to use their credit lines (Campello, Giambona, Graham and Harvey, 2011). This is not surprising as access to credit lines becomes more restricted following declines in borrower profitability (Sufi, 2009) and banks tend to increase interest rates and make loan provisions less borrower-friendly when firms, faced with a cash flow shock, draw on or increase their credit lines (Brown, Gustafson and Ivanov, 2020).
Besides drawing down credit lines Acharya and Steffen (2020) show that firms also raised cash by accessing bond markets, but this started later. New bond issuance was muted until mid-March but accelerated after the Fed announced its corporate bond purchase programs through which it can purchase investment-grade rated corporate bonds (including ‘fallen angels’) and ETFs. The surge in terms of volume was driven almost entirely by AAA-A-rated companies. However, the dollar volume of bond issued by BBB-rated firms also increased substantially after 23 March, with growth rates similar to that of AAA-A-rated companies. Not surprisingly, yields were substantially higher for all firms issuing new debt.
Cash is king
Cash is clearly the king of liquid assets during Covid-19. Existing credit lines can and do provide firms with additional resources to help them meet short-term liquidity needs. But they often have a short maturity, are more expensive and it is uncertain whether banks will renew them (Campello, Giambona, Graham and Harvey, 2011). Fortunately, corporate liquidity positions of firms in advanced economies appear stronger than they were at the onset of the global financial crisis. This is partly a consequence of a general increase in corporate cash holdings in many economies since the mid-2000s (Dao and Maggi, 2018), but also a reaction to the financial crisis itself as firms tend to shore up their liquidity after a financial or economic shock (Almeida, Campello and Weisbach, 2004; Berg, 2018).
However, a substantial number of firms have inadequate liquidity buffers. Banerjee, Illes, Kharroubi and Garralda (2020) estimate that 25% of the firms in advanced and emerging economies do not hold enough cash to cover their debt obligations. The Bank of England (2020) estimates that before the Covid-19 shock, only one third of UK companies held liquidity buffers that were larger than three months’ worth of their turnover.
While it is still very uncertain how the Covid-19 induced crisis will unfold and to what extent it will resemble the global financial crisis, some lessons from the global financial crisis might be good to keep in mind. Joseph, Kneer, Van Horen and Saleheen (2019) show that during the global financial crisis companies with limited cash holdings had to reduce their investment and therefore lost productive capacity. When demand returned and market conditions improved they were not able to catch up with their cash-rich rivals and as a result lost market share to them. Companies with large amounts of cash on their balance sheets at the onset of the coronavirus crisis might therefore emerge as winners in the post-Covid world.
Cash might be king, but leverage is critical as well. While UK corporate debt servicing has been improving in recent years, total debt owed by UK corporates has grown steadily in recent years (Bank of England, 2020). Papers studying the global financial crisis provide ample evidence that firms that needed to roll-over large amounts of debt during the crisis experienced larger employment losses (Giroud and Mueller, 2017), invested substantially less (Kalemli-Ozcan, Laeven and Moreno, 2020) and experienced a persistent decline in total factor productivity (Duval, Hee Hong and Timmer, 2019). Therefore it is not surprising that stock market reactions were more muted for firms with lower levels of debt.
Firms that are cash rich, have low leverage, and have a flexible cost base are more likely to be resilient to the Covid-19 shock and might be able to improve their competitive positions when the recovery sets in. However, it is crucial that temporary liquidity problems of otherwise viable firms do not turn into solvency problems as this will lead to longer-term economic damage. This highlights the importance of government schemes and continued lending by banks to ease funding shortages of firms.
Neeltje van Horen works in the Bank’s Research Hub Division.
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