This piece is also published in German on Makronom.
Historically, economic downturns are associated with increases in business insolvencies. Figure 1 shows that during the Great Financial Crisis, insolvencies increased, but in the current, deeper recession, such an increase has not (yet) materialised. In fact, the rate of insolvencies has been remarkably stable or has even dropped over the course of the COVID-19 crisis.
Beyond the massive policy support in response to COVID-19 (accommodative monetary policy, direct liquidity relief to the private sector, government-financed job retention programmes, debt moratoria, credit guarantee programmes and direct grants to businesses), policymakers have swiftly enacted temporary legal changes to their bankruptcy rules. The intention has been to reduce the number of companies starting insolvency procedures and to avoid the overwhelming of court capacities. Table 1 summarises these amendments for major countries.
One measure has been suspension of the duty to file for insolvency, which was enacted in Germany, France and Spain in March. While the suspension has been extended twice in Germany, it expired in France on 24 August and temporarily in Spain during summer 2020 as the state of emergency was lifted. In the United Kingdom, firms in financial distress can enter a company moratorium of 20 business days, which provides a payment holiday and protection from creditor enforcement, and during which companies can develop a restructuring plan to pursue outside a formal insolvency process. The UK government furthermore restricted the use of winding-up petitions in order to protect commercial tenants from rent collection by landlords. Finally, the United States increased access to a streamlined restructuring process for small businesses by raising the debt-limit eligibility threshold of the Small Business Reorganization Act. While the total number of firms entering insolvency proceedings has stayed constant in the US during the pandemic, the number of restructurings has increased, while liquidations have declined.
This unprecedented government support for the private sector has major economic implications.
These measures were necessary to protect viable companies from the shock. The lockdowns have hit sectors that were viable before the crisis, that were not engaged in excessive risk taking, and that should rebound quickly once the pandemic is over. Moreover, a surge in insolvencies could have had devastating macroeconomic ripple effects. For every firm that closes, workers lose their jobs, resulting in lower labour tax income, higher unemployment benefit expenses and lower household consumption. Research shows that unemployment increases threefold if a drop in GDP is accompanied by an increase in corporate bankruptcies of a similar magnitude. In recessions like the current one, when insolvencies are concentrated in specific sectors, unemployment is even more persistent because sector-specific human capital slows labour reallocation. Finally, withdrawing government support could tighten credit markets. The legislative amendments that are currently active not only inhibit the registration of new insolvencies, but also delay the progress of ongoing procedures, meaning that losses from non-performing loans do not yet formally appear on banks’ balance sheets. A wave of corporate defaults could strain banks’ loss-absorbing capacity and lead to tighter financing conditions, resulting in a growing share of firms without access to liquidity, and potentially triggering a vicious circle.
But measures taken to avoid the liquidation of viable firms also create opportunities for unviable firms to survive. As a result, valuable resources could be inefficiently allocated away from more productive businesses in the economy, slowing growth in the future. This problem is not new, and the debate on the zombification of some parts of the European economy started well before the COVID-19 crisis. This has been amplified by the crisis but the main problem is that the unusual characteristics of this crisis make it extremely difficult to distinguish viable from unviable businesses in distress. A July 2020 study from France shows that the share of highly-productive companies among those facing insolvency is disproportionately high. Withdrawing government support too early risks pushing also those viable yet illiquid companies out of business.
Policymakers thus face a difficult trade-off. Supporting unproductive and unviable firms for too long could slow economic growth in the future, while withdrawing support prematurely will deepen the ongoing recession, potentially leaving lasting scars on the economy. Attempting to target support by differentiating real zombies from those firms that would be viable in the absence of the pandemic is a difficult and costly task with high downside risk.
As Europe faces a second and possibly third wave of the pandemic, policymakers should therefore maintain the support as long as necessary. The measures have been effective so far in preventing mass unemployment (current measures in Europe to prevent insolvencies can by themselves save 15% of jobs, according to the International Monetary Fund) and enabled the partial, but unexpectedly strong, economic rebound during the third quarter of 2020.
But corporate debt levels continue to rise. In the euro area, corporate debt rose by 7.5 percentage points of GDP between the fourth quarter of 2019 and the second quarter of 2020. In the US it rose by 10 points. Policymakers need to prepare for the wave of insolvencies that could quickly arrive once the current measures are lifted.
In Europe, persistent inefficiencies in insolvency procedures should be addressed. The average recovery rate of insolvency procedures in the EU is, at 62 cents on the dollar, far below that of the UK (85 ct/$) or the US (81 ct/$). Findings from the European Banking Authority suggest that recovery rates in Europe might be even lower, with estimates ranging from 34 ct/$ to 40 ct/$ for SMEs and corporates. In addition, insolvency procedures in the EU take on average twice as long as in the UK and the US, and many frameworks in the EU favour liquidation, meaning the dissolution of the business and sale of its assets, over restructuring, thus failing to protect remaining entrepreneurial value. This is especially pronounced in central and eastern Europe, where only Slovenia and the Czech Republic are considered to have minimally burdensome insolvency procedures according to the World Bank.
By reforming insolvency processes, policymakers can tackle two critical impediments to economic growth in the years of recovery. In general, the focus should be on amendments that simplify procedures, expand court capacity and address the bureaucratic load. More specifically, ensuring that existing laws don’t punish business failure excessively would strengthen market selection by facilitating firm exit and entry. Legislators should also reduce barriers to corporate restructuring, for example by allowing early restructuring or creating cheaper procedures for SMEs, to avoid liquidations and the ensuing loss of business value. At EU level, policymakers should push for progress on the Restructuring and Second Chance Directive, which aims to increase the coherence of insolvency procedures in EU countries and would introduce targeted measures to improve efficiency of insolvency procedures in the bloc. This would benefit the economy by promoting investment, innovation and economic growth, and would also represent an important step towards a capital markets union, notwithstanding that these structural changes will take time and are unlikely to have immediate effect.
Claeys, G., M. Hoffmann and G. Wolff (2021) ‘Corporate insolvencies during COVID-19: keeping calm before the storm’, Bruegel Blog, 7 January