Sudipto Karmakar, Alexandra Varadi and Sarah Venables
This post reviews the literature on the consequences of debt for corporate and macroeconomic outcomes, drawing both on the pandemic period and on previous financial crises. Lessons from previous crises show that high leverage can amplify corporate risks and economic downturns by: increasing reliance on external financing that may dry up in stress; through debt overhang problems; or by increasing linkages between corporates and other sectors of the economy. Corporate debt may also be correlated with negative outcomes in the pandemic as well, but it is still early to draw direct conclusions.
UK corporate leverage before the pandemic
In aggregate, UK corporate leverage appeared manageable at the start of 2020. Debt-to-earnings ratios were below those observed in the global financial crisis and debt-servicing burdens of UK corporates remained low, supported by low interest rates. But the aggregate position may have concealed vulnerabilities in particular companies. The share of highly leveraged UK companies had been increasing slowly over time, in part facilitated by the growth in so called ‘leveraged loans‘. Highly leveraged listed companies accounted for 21% of aggregate turnover in 2019 H1, compared to 12% in 2018 (May 2020 Financial Stability Report). And, debt to earnings increased steadily since 2015, reaching levels above other developed countries prior to the pandemic (Chart 1).
Chart 1: Non-financial corporate debt as a proportion of earnings(a)(b)
Source: Multiple sources.
(a) Gross debt to earnings is calculated as gross debt as a percentage of a four-quarter moving sum of gross operating surplus. Gross operating surplus is adjusted for financial intermediation services indirectly measured.
(b) UK and US series include only private corporations; eurozone series also includes state-owned corporations.
What can previous crises tell us about the risks that high corporate indebtedness could create for the Covid-19 (Covid) crisis recovery?
Historical analysis shows that firms’ choice of debt versus equity affects incentives within the firm, leading to a ‘debt overhang’ problem if owners are less inclined to invest when any benefits will accrue to debtors (Myers (1977) and Jensen and Meckling (1976)). More recently, Brunnermeier and Krishnamurthy (2020) use a simple model to illustrate how debt overhang could create distortions, such as underinvestment, leading firms to reduce employment, sacrifice expenditures that maintain franchise value and postpone filing for a bankruptcy longer than is socially optimal.
Corporate sector vulnerabilities may also increase after a shock if businesses’ access to external finance is restricted as credit supply tightens. This may prevent corporates from refinancing existing debt or from meeting temporary cash-flow deficits, resulting in a reduction of firm investment and employment.
Kiyotaki and Moore (1997) show that more indebted firms are likely to invest less after a negative shock due to credit constraints tightening as collateral loses value. This hurts firm performance next period, further reducing their net worth and overall investment. The authors show that through this channel, borrowing secured on assets can amplify the initial effects of temporary negative shocks. In the US, research using local market concentration (Greenstone et al (2014)) and firm-level banking relationships (Chodorow-Reich (2014)), as a proxy for credit access, showed that supply-side credit constraints during the global financial crisis were associated with cuts in employment. Hochfellner et al (2015), Bentolila et al (2017), Buera and Karmakar (2019) and Franklin et al (2020) find similar results in Germany, Spain, Portugal and the UK respectively. These studies suggest challenges in accessing corporate credit during recessions may exacerbate unemployment trends.
Reliance on short-term debt or pressures to refinance during a crisis may amplify corporate stress. Duchin et al (2010) finds larger cuts in investment during the 2008 financial crisis for US firms with higher levels of short-term debt. Similarly, Almeida et al (2012) find that companies with debt maturing at the nadir of the financial crisis cut investment significantly more than those with debt maturing after 2008. Buera and Karmakar (2019) document that companies with significant amounts of short-term debt found it difficult to roll-over the debt in the aftermath of the sovereign debt crisis, and subsequently contracted more in terms of employment and investment. Evidence from the euro area (Kalemli-Ozcan et al (2019) and Gebauer et al (2017)) also shows that firms with higher debt levels and a higher share of short-term debt reduce their investment more after the crisis. This negative effect is stronger for firms linked to weak banks in the aftermath of a crisis.
High leverage can amplify linkages between corporates and the wider economy. For instance, research suggests a link between corporate leverage and consumer demand in times of stress. Giroud and Mueller (2017) find that firms with higher leverage prior to the global financial crisis experienced larger employment losses following the decline in consumer demand brought on by the crisis.
High corporate leverage may also increase the sensitivity of corporates to the housing market. Bahaj et al (2019) find that more levered firms with a higher reliance on directors’ homes as a source of collateral for corporate loans, adjust employment the most following a change in monetary policy. Thus, the paper finds a direct link between the performance of leveraged firms and residential house prices.
Finally, Chen and Manso (2017) find that the cost of debt overhang increases substantially with macroeconomic risk and with the leverage position of the firm. In recessions, the debt-overhang costs are up to three times larger for highly leveraged firms compared to low leveraged ones.
Were highly indebted firms more vulnerable coming into the Covid crisis?
The literature emerging in the Covid crisis has begun to examine whether corporate leverage affected firms’ performance during the pandemic. We review part of the literature here while noting that it is too early to come to any definitive conclusions.
Researchers at the New York Fed argue that highly leveraged firms face a higher risk of becoming insolvent than their less-leveraged peers since they must continue to make interest payments on their debt even when their business may have slowed. The authors used public fillings through 2020 and document that highly leveraged sectors experienced a far greater decline in cash flows than a reduction in interest expenses. Carletti et al (2020) use a sample of Italian firms to show the heterogeneous effects of the Covid shock on corporates, in terms of reduction in profit and equity levels. The authors predict more distress among small and medium-sized enterprises, firms with high pre-crisis leverage, and firms belonging to the Manufacturing and Wholesale Trading sectors.
The adverse effects of leverage were evident in the stock market as well. Ramelli and Wagner (2020) show how corporate leverage and cash holdings drove firm value in the recent crisis. They show that investors (and analysts) were wary of the performance of firms with high leverage and low cash, when lockdowns were imposed in Europe and USA. Ding et al (2020) use data on 6,000 firms across 56 economies to show that the pandemic-induced drop in stock prices was greater for firms that had weaker pre-2020 financials (lower cash, higher debt and lower profits). Similar results are documented by Fahlenbrach et al (2020) who find that firms with more short-term debt, less cash, and more long-term debt experienced a higher stock price drop in response to the Covid shock. Relatedly, Pettenuzzo et al (2020) show, using data on US companies, how highly leveraged firms and firms with low profitability were more likely to have suspended their dividend payments during the pandemic. Alfaro et al (2020) also analyse stock market outcomes but use a simple epidemiological model to do so. The authors document results that echo earlier findings, namely, that Covid-related losses in market value at the firm level increase with capital intensity and leverage.
The academic literature suggests a strong negative relationship between debt and subsequent performance in previous financial crises. There are signs that corporate debt may be correlated with negative outcomes in the pandemic as well, but it is still early to draw direct conclusions. There has been an array of policy responses from governments to support corporates and ensure that some of the negative channels of transmission of shocks, described above, are mitigated. Prompt policy responses have mitigated some supply-side issues by reducing the cost of borrowing and by offering alternative government-backed lending. The financial sector also entered this shock with higher capital and greater resilience, which has also helped mitigate supply-side challenges. Some open questions remain however. For example, firm heterogeneity, such as size, sector, profitability and productivity, is also likely to play a key role in determining the effects of leverage on the real economy as the economy recovers from the pandemic. It might well be the case that the distribution of debt matters more than the overall amount. And it is too early to assess and quantify how effective support programs have been in affecting the relationship between pre-shock debt levels and subsequent investment during the Covid shock period.
Sudipto Karmakar, Alexandra Varadi and Sarah Venables work in the Bank’s Macro-financial Risks Division.
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