Assessing corporate vulnerabilities in the euro area

Prepared by Giulio Nicoletti, Ralph Setzer, Mika Tujula and Peter Welz

Published as part of the ECB Economic Bulletin, Issue 2/2022.

1 Introduction

The coronavirus (COVID-19) crisis was a major shock for the non-financial corporate (NFC) sector. The pandemic and the associated containment measures translated into a large drop in sales for firms. The rapid pace of the decline in revenue in conjunction with the difficultly of adjusting costs sufficiently quickly led to a sudden increase in liquidity needs. These liquidity needs, if left unaddressed, could have easily morphed into broader solvency issues, leading to a sharp increase in corporate defaults and bankruptcies.

The COVID-19 pandemic hit the services sector and small firms particularly hard. There is a high concentration of small businesses in contact-intensive sectors. This creates additional challenges when assessing the vulnerability of the euro area economy, as comprehensive information on the health of small companies’ balance sheets typically becomes available only with significant time lags. The information contained in the Survey on the Access to Finance of Enterprises in the euro area (SAFE) was particularly useful to fill, at least partially, the information gap.^[1]

The timely and forceful policy response at national and EU level mitigated the short-term impact of the pandemic. Fiscal, monetary and supervisory measures have substantially supported corporates by preventing large corporate losses and a rise in non-performing loans for banks. Government support to firms helped to reduce their costs (for instance via job retention schemes) and provided liquidity support, while monetary policy helped to provide favourable financing conditions and supervisory policies freed up capital that banks could use for lending. The effect of these policy measures is also reflected in exceptionally low numbers of corporate insolvency cases over the past two years.

Two years after the onset of the pandemic, the short-term vulnerabilities of the corporate sector seem to have abated somewhat amid the ongoing recovery, but risks remain, especially for smaller firms and for sectors most affected by the pandemic. Corporate revenues recovered after some of the strictest containment measures were eased, thus also improving debt servicing capacity. At the same time, weaker corporate balance sheets and heterogenous indebtedness across firms pose risks to the recovery. Higher gross corporate debt, in particular for those firms that also face an increase in net debt, may hamper the capacity of firms to support the recovery via an increase in capital spending, especially once policy support is phased out. The higher debt ratios render firms vulnerable to potential shifts in risk sentiment, a rise in real interest rates or a fall in profits. Weaker corporate balance sheets also pose a risk for banks, potentially activating adverse feedback loops and financial stability concerns through increases in non-performing loans and corporate bankruptcies.

Aside from the COVID-19 pandemic, the corporate sector also faces broader structural challenges. The pandemic has accelerated several structural transformations already under way in the euro area economy. A non-exhaustive list of structural challenges includes new forms of work (including remote working), the use of e-commerce and digital technologies, a reconfiguration of global value chains and the transition to a carbon-neutral economy. Such changes require a comprehensive modernisation of firms’ capital stock, which may be harder for small and medium-sized enterprises (SMEs) to implement, partly owing to their pre-existing weaknesses compared with larger firms.

This article is structured as follows. Section 2 reviews recent developments, focusing on vulnerabilities stemming from corporate indebtedness. Section 3 looks at implications for corporate insolvencies, complemented by Box 1, which views this through the lens of bank asset quality. Section 4 looks at the possible investment implications of increased levels of corporate indebtedness. Box 2 discusses some structural features of euro area SMEs in the context of the COVID-19 pandemic. Section 5 concludes.

2 Recent developments in the non-financial corporate sector

Euro area NFC sector gross indebtedness increased strongly during the pandemic. The NFC gross debt-to-value added ratio (debt ratio) increased by 18.8 percentage points between the end of 2019 and early 2021, to peak at 164.4%, only 0.5 percentage points lower than its record in early 2015 (Chart 1, panel a). This increase was explained almost equally by firms’ stronger recourse to debt financing and by the marked decline in gross value added. At the end of the third quarter of 2021, the debt ratio still stood 10.6 percentage points above its level at the end of 2019, which is almost entirely due to stronger recourse to debt financing rather than lower gross value added (Chart 1, panel b). The debt-to-equity ratio also increased significantly between the fourth quarter of 2019 and the third quarter of 2021, as the increase in debt was compensated only partly by greater equity issuance.

The increase in gross NFC debt has been accompanied by a strong accumulation of liquid assets, especially by large corporates. NFC deposits increased by €713 billion between the fourth quarter of 2019 and the third quarter of 2021. As a result, the net debt ratio increased much less than gross indebtedness, and in the third quarter of 2021 net debt stood 0.4 percentage points below its level at the end of 2019 (Chart 1, panel b).^[2] During the early stages of the pandemic, firms parked a substantial part of the proceeds from new bank loans and debt securities issuance in deposits in order to pre-fund working capital needs and necessary investment, as well as to prepare for possible cash shortages due to the collapse of sales and operating cash flows. More recently, the improvements in profits and retained earnings have contributed to an increase in liquid asset holdings. These holdings can act as a mitigating factor for high corporate debt at an aggregate sectoral level.^[3]

Indebtedness remains significantly above a benchmark level estimated on the basis of macro-financial conditions. Since mid-2020 gross indebtedness has exceeded its estimated benchmark level by a large margin (Chart 2).^[4] Observed indebtedness rose sharply after the end of 2019, mirroring the marked increase in borrowing in the period from March to June 2020. Meanwhile, benchmark indebtedness declined strongly in the second quarter of 2020 and has since remained significantly below actual indebtedness. This was due first to the collapse of economic activity and then to its continued weakness, which historically would normally have been accompanied by lower indebtedness. The observed indebtedness also exceeded by a considerable margin its benchmark level between the end of 2006 and early 2010. This period was characterised by strong credit growth in the run-up to the global financial crisis in 2008 and a collapse in economic activity after the crisis erupted, followed by a lengthy period of deleveraging. The gap is projected to narrow and close in the coming quarters as the debt overhang and liquid asset holdings limit the demand for debt financing and the economy recovers.

The uneven distribution of debt reflects vulnerabilities among SMEs and micro firms – especially in the sectors most affected by the pandemic. Gross debt increased to different degrees across firms, depending on their exposure to the COVID-19 pandemic and the related lockdown measures. Among listed firms, those with sales below the median in 2020 increased their debt by about 3 percentage points more than firms with sales above the median (Chart 3). While data for non-listed companies are not available, estimates based on sectoral turnover suggest that for an average firm in the most affected sectors (e.g. accommodation), the increase in leverage could be close to 10 percentage points, even after considering a scenario in which only a third of corporate losses are filled by additional debt (the red line in Chart 3), while the rest are offset by government support policies.

There are also significant differences in corporate indebtedness across countries. The NFC gross debt-to-value added ratio amounted to close to 200% in France in the third quarter of 2021, compared with around 120% in Germany (Chart 4, panel a). In France, the gross debt ratio has increased continuously since the end of 2007, as firms have financed their capital expenditure and mergers and acquisitions mostly with debt instruments. In Germany, indebtedness remains significantly lower than in other large euro area economies, as firms had financed their expansion mainly with internal funds before the pandemic. At the same time, the increase in the debt ratio since the end of 2019 was most significant in Spain, where, like in Italy, a large part of the decline observed between 2012 and 2019 was reversed (Chart 4, panel b). The decline in the level of net debt was particularly large in Italy, while in Germany, France and Spain net debt has increased (Chart 4, panel c). Differences between countries in the size of debt increases during the pandemic can largely be explained by (i) differences in the severity of the COVID-19 crisis and the resultant length and extent of lockdowns, (ii) differences in the take-up of state-guaranteed bank loans, and (iii) differences in economic and financial structures.

Despite the increase in gross indebtedness, the debt service burden has continued to decline to new record lows. Gross interest payments by firms in the large euro area countries have decreased by between 1.8% and 9.1% since the end of 2019, despite the increase in the level of debt. This decline reflects the favourable financing conditions promoted by the policy response to the crisis, which have alleviated corporate debt sustainability concerns and supported the recovery. However, debt servicing costs as a percentage of profits continue to vary significantly across countries (Chart 5, panel a). This mainly reflects differences in gross debt levels and sectoral compositions across countries, the latter of which affects the gross operating surplus-to-value added ratio (Chart 5, panel b).^[5]

Government and supranational support measures have contributed to a sizeable reduction in the liquidity risks of firms.^[6] First, governments provided loan guarantees and direct liquidity support to corporates, while short-time working arrangements alleviated the wage bill. Second, deferrals of social security contributions and taxes also supported the liquidity position of firms. In aggregate, corporates received around €550 billion through these direct and indirect government support measures (Chart 6). Without these measures, corporate savings net of capital depreciation would have been significantly negative in 2020. Third, temporary supervisory measures for banks allowed them to offer loan payment moratoria. Fourth, the ECB provided support through its monetary policy measures. Firms also markedly reduced their investment expenditure compared with 2019. Total net credit flow was about €280 billion higher in 2020 than in 2019, supported to a considerable extent by the third series of longer-term refinancing operations (TLTRO III), the pandemic emergency purchase programme (PEPP)^[7], government loan guarantees and supervisory measures.^[8] All in all, NFC cash holdings increased by about €400 billion more in 2020 than the year before, although the increase was mainly concentrated in large firms. Also, in 2021 firms received significant amounts of extra resources from governments (about €325 billion), which further limited the decline in savings.

The improved debt servicing capacity of firms and low financing/rollover risks underpin the currently moderate level of corporate vulnerabilities. NFC vulnerabilities – as measured by the ECB’s composite vulnerability index based on aggregate data – increased sharply following the outbreak of the COVID-19 pandemic, exceeding by a large margin the levels observed in the aftermath of the global financial crisis (Chart 7, panel a).^[9] The rise was mostly driven by a fall in activity and profitability and an increase in leverage. However, the corporate vulnerability index has been declining since mid-2020, reaching a historical low in the second quarter of 2021. This reflected increases in the interest coverage ratio and savings, the very low cost of debt financing, the record high cash holdings and the observed shift from short-term debt financing towards instruments with longer maturities. Leverage also contributed slightly to the decline in the vulnerability index in the third quarter of 2021. This was because of the decline in the gross and net debt ratios following the continued improvement in the economy and the significant accumulation of cash at the height of the pandemic. However, the gross debt and debt-to-equity ratios remain at elevated levels and significantly above their end-2019 levels, increasing firms’ sensitivity to negative shocks. A counterfactual exercise shows that without the combined policy interventions, the vulnerability index would have reached a considerably higher value in mid-2020 and remained significantly above its current level (Chart 7, panel b).^[10]

3 Corporate balance sheet health and insolvency risk

Corporate insolvencies during the COVID-19 pandemic turned out to be historically low. In the past, insolvencies tended to be countercyclical and to lag real GDP growth (Chart 8, panel a). In 2020 this relationship between economic growth and insolvency procedures broke down. A key reason was the policy measures that were implemented to attenuate the negative economic effects of the pandemic crisis. As a result of these measures, insolvencies did not rise along with the collapse in economic activity. Instead, they decreased by around a third in 2020 and remained at low levels throughout 2021.

There are sizeable gaps between the predicted and observed number of insolvencies in the euro area. Insolvencies are predicted using country-level models reflecting the historical relationship between real GDP, unemployment and insolvencies. In 2020 the predicted number of insolvency cases for the four largest euro area countries exceeded observed cases by around 50% (Chart 8, panel b). In addition to policy support, these large gaps may also reflect business closures without insolvency procedures, especially for very small SMEs and sole proprietors. Overall, the large estimated insolvency gaps in conjunction with the fact that debt increases are more likely for smaller firms suggests that insolvency cases could still rise, particularly among smaller firms in sectors that are most affected by the pandemic.^[11]

On aggregate, the balance sheets of firms suggest limited insolvency risks. The Altman Z-score^[12] provides one indicator for assessing corporate balance sheet health and insolvency risk. While this indicator was designed to assess the insolvency risk of an individual firm, it can also be computed for the NFC sector as whole, as the availability of timely data is better at the aggregate level than for individual non-listed companies. At the country level, the index shows a negative relationship with insolvencies (Chart 9, panel a). Following a sharp deterioration in 2020 due to the pandemic, the Z-score partially rebounded in 2021, reflecting improved corporate balance sheets.

The recent general decline in insolvencies notwithstanding, developments are heterogenous across countries. Differences persist in national insolvency laws and in the culture of using insolvency procedures to close a business. Other ways of handling solvency problems include, for example, voluntary closures and out-of-court procedures. Such differences also affect the link between insolvencies at firm level and macroeconomic developments.^[13] Although all euro countries introduced temporary relief from existing insolvency rules, there were notable differences in scope and time. National differences, whether structural or temporary, are reflected in different insolvency rates across countries (Chart 10, panel a), in differences in estimated insolvency gaps (Chart 8, panel b) and in the varying linear relationships between Altman scores and the number of insolvency cases.

There are also noteworthy differences in the functioning of insolvency frameworks across euro area countries. For example, the recent European Banking Authority insolvency benchmarking exercise found that recovery value and recovery time vary substantially across euro area countries.^[14] For the euro area, the recovery of value from a distressed SME loan takes around four years on average, and creditors recover only about 40% of the loan amount (Chart 10, panel b). Unfavourable insolvency procedure metrics could be a motivation for seeking alternative ways to restructure or close a business.

Whether insolvencies and business closures will rise in the future also depends on how vulnerable corporates are to future economic shocks. Corporate vulnerabilities judged through the lens of bank asset quality suggest that some deterioration could be observed during the pandemic (Box 1), as also reflected in the vulnerability index shown in Chart 7 and the Altman score shown in Chart 9, panel b. The vulnerability index is projected to remain significantly below its average historical level at least until the end of 2024, indicating a limited level of corporate vulnerability. This outcome is, however, conditional on a further strengthening of economic activity and favourable financing conditions, which would keep the cost of debt servicing low.

4 The impact of weakened corporate balance sheets on investment

The increased corporate indebtedness could inhibit investment spending and the economic recovery. Even if insolvencies were not to rise strongly in the period ahead, the increase in the corporate debt burden compared with the pre-COVID-19 period as well as the heterogenous distribution of debt across firms could still put a drag on the economic recovery by impeding investment growth. This could occur through several channels. High corporate indebtedness implies higher interest expenses and thus fewer funds available for investment. Firms with high leverage also find it harder to obtain new funds from external sources due to their higher default risk. Moreover, the desire to repair weak balance sheets leads firms to deleverage, and thereby forgo investment opportunities, potentially with negative implications for profits as well.^[16]

A negative link between high debt and investment is empirically well established. A large body of literature has investigated the link between indebtedness and investment at the firm level. Recent studies highlight in particular the non-linear nature of this relationship by identifying a threshold level beyond which the structural relationship between debt and investment changes.^[17] While low and medium levels of leverage do not have a negative impact on investment, highly indebted firms report lower investment (Chart 11, panel a). Empirical evidence for the euro area suggests that in particular a sizeable number of micro, small and medium-sized firms are located in “vulnerability regions” where debt, and hence reliance on external finance, negatively affects investment. By contrast, investment by larger firms, which typically face lower financial frictions, does not seem to be influenced by higher leverage (Chart 11, panel b).

High debt is associated with low investment in the aftermath of economic crises. The sensitivity of investment to debt differs in economic booms and economic busts. ECB analysis based on firm-level data for 14 euro area countries from 2005 to 2018 suggests that investment by high-debt firms is significantly depressed for an extended period following an economic crisis.^[18] Over the four years after a large economic contraction, the growth rate of tangible fixed capital of high-debt firms is some 15 percentage points below that of their counterparts with lower debt burdens (Chart 12, panel a). This result is driven in particular by micro firms, which experience a more protracted fall in investment post-crisis than larger firms (Chart 12, panel b). Applying these findings to the COVID-19 crisis suggests that the COVID-19 shock may lead to a 5% drop in the aggregate stock of tangible fixed assets by 2024.

Improving the equity position of firms could strengthen the prospect of sustainable investment growth in euro area countries. Investment needs in the post-COVID-19 period are likely to be substantial. The COVID-19 pandemic has accelerated large-scale structural transformations that are likely to be associated with high investment needs. New forms of work that necessitate additional hardware and software to allow staff to work from home effectively, an increased take-up of digital technologies and the transition to a carbon-neutral economy all require a comprehensive modernisation of firms’ capital stock. The European Commission estimates that the private and public investment needs related to the green and digital transitions will amount to nearly €650 billion per year until 2030, corresponding to 4.5% of EU GDP in 2021, and around one-fifth of total private and public investment in the EU in 2021.^[19] Such high levels of investment would be facilitated by a corporate sector that improves its ability to access the credit needed by strengthening its reliance on equity instead of debt.^[20]

5 Conclusions

Corporate indebtedness increased during the pandemic. On aggregate, firms’ higher debt has been partly offset by additional cash holdings, especially for larger firms. Bank loans and policy support have helped to cover the liquidity needs of firms and mitigate the risk of immediate insolvencies as cash flows plummeted. As a result, the number of corporate bankruptcies in the euro area has declined significantly since the start of the pandemic, reinforced by the suspension of mandatory insolvency filings in some countries. Corporate insolvency rates are likely to rise, but probably by less than would be predicted by historical regularities.

The heterogenous impact of the pandemic on the balance sheets of firms and ongoing structural transformations will influence the outlook for the corporate sector. High corporate leverage could deter investment during the recovery. While large firms are more resilient to future shocks on account of their large cash holdings, a failure to address the high leverage of SMEs, most notably in sectors hit hard by the pandemic, could also lead to an increase in the number of non-viable firms, which could crowd out viable firms from available credit. This would negatively affect the capacity of the corporate sector to pursue the investment required to support the green and digital transitions.

Broadening the funding sources of firms beyond debt financing could foster sustainable investment growth. Several measures have been proposed to strengthen incentives for private investors to provide equity to viable firms in distress or support balance sheet restructuring.^[25] These include reducing the tax bias against equity financing and ensuring access to timely and reliable information for equity investors. Changes to accounting rules could improve access to equity provided by private investors, with notable benefits for SMEs.

Sound structural policies could further promote the capacity of the corporate sector to support the recovery. Shorter insolvency procedures might enable a smoother reallocation of resources from less productive firms to firms that are more likely to thrive in the post-pandemic economy. Reducing barriers to entry and investment for new, innovative market entrants could further strengthen the corporate sector, especially through greater use of digitalisation and low-emission technologies. Advancing the banking and capital markets unions and rolling out the Next Generation EU programme could play a strong supporting role in increasing corporate resilience and strengthening the recovery.^[26]