“We have only just overcome the liquidity phase of the crisis in countries that are now relaxing restrictions. In many others, the health crisis is still acute. And the epidemic could flare up again anywhere,” the general manager, Agustin Carstens, of Bank for International Settlements (BIS) acknowledged in late June whilst discussing the Bank’s 2020 “Annual Economic Report”. “Importantly, the shock to solvency is still to be fully felt. Business insolvencies and personal hardship may well increase.”
There has been much optimism in recent months regarding the prospects of a global recovery from the coronavirus. The recent announcements of vaccines with high levels of efficacy from the likes of Pfizer and Moderna have certainly raised hopes of a return to normal—or, indeed, a “new normal”—at some stage. And while such news should have positive implications for the economy in the long run, several underlying weaknesses are likely to remain for some time. Among the most concerning is the likely emergence of a solvency crisis, whereby companies’ liabilities swell to such a degree that they are unable to pay down their debts and are thus likely to file for bankruptcy.
With the pandemic forcing brutal shutdowns across much of the world, many companies initially took on substantial amounts of debt to address the immediate liquidity constraints they faced. According to research on the largest 900 non-financial companies in the world compiled by Janus Henderson Investors and published in July, up to $1 trillion of new debt will have been added in 2020 on the back of companies’ attempts to shore up their finances against the coronavirus. The UK asset-management group found that company borrowings around the world had already risen to a record $8.3 trillion in 2019, which was 8.1 percent more than the previous year and the fastest annual increase in at least five years. And now, thanks to the coronavirus, net borrowings will have jumped by a further 12 percent in 2020. “COVID has changed everything,” acknowledged Seth Meyer, a portfolio manager at Janus Henderson. “Now it is about conserving capital and building a fortified balance sheet.”
Despite such attempts at preservation, however, 2020 has been characterised by a sweeping wave of corporate deterioration, which in turn has triggered widespread credit downgrades and even defaults in many instances. S&P Global Ratings, for example, lowered 414 US corporate long-term issuer credit ratings in the second quarter as the country’s economic recession deepened. This number easily surpasses the previous all-time record of 331, set in 2009’s first quarter at the trough of the global financial crisis.
And in October, the ratings agency predicted that COVID-19 would double corporate default rates across the United States and Europe by June 2021, anticipating that the US’s corporate default rates will rise from 6.2 to 12.5 percent and Europe’s from 3.8 to 8.5 percent. Alexandra Dimitrijevic, S&P’s global head of research, also confirmed that the number of firms on downgrade warnings are at record levels—37 percent of the companies and 30 percent of the banks that S&P rates—and that default rates were set to jump. “One third of speculative-grade companies are rated B- or below in Europe, which is up 10 percentage points compared to before the (COVID) crisis. So that is why we expect the default rate to effectively double.”
All in all, then, the pandemic has left a number of businesses—and, indeed, entire industries such as physical retail and travel—struggling to survive, which has considerably raised the likelihood of a wave of bankruptcies sweeping across the world in the near future. Indeed, research by trade-credit-insurance and risk-management company Atradius estimated that global corporate insolvencies would increase by a whopping 26 percent in 2020, with all major regions expected to be vulnerable. Turkey, the United States, Hong Kong SAR, Portugal, the Netherlands and Spain are among the countries expected to experience the largest increases in insolvencies. “In the United States, although the recession is not expected to be as deep as in the Southern European countries, insolvencies are highly responsive to fluctuations in economic activity,” the research stated. “Moreover, the effectiveness and the scale of the PPP [Paycheck Protection Program]…are likely to remain lower than in the European countries, which provided generous liquidity assistance through wage subsidies.” As such, Atradius found that the lowest expected increases in insolvencies are all found in Europe. “In Germany, France, Austria, Belgium, Switzerland and Italy, insolvencies are likely to go up by percentages ranging from 6 percent to 20 percent.”
Among the most pertinent concerns emanating from such forecasts is that as companies with consistently declining credit quality and weak balance sheets begin to emerge from the crisis, they are highly likely to refinance the debt they have accumulated. Ultimately, this could lead to a widespread solvency crisis. Anne Richards, the chief executive officer of Fidelity International, warned in June of just such a scenario, suggesting that the asset-management industry will struggle to provide sufficient capital to solve the problems facing public businesses as economies recover from lockdowns. Even though the Bank of America Securities Global Fund Manager Survey showed that fund managers were globally sitting on larger than normal cash amounts back in May—at 5.7 percent versus a 10-year average of 4.7 percent—that figure dropped to just 4.1 percent in November, underlining Richards’ warning that there is not a substantial amount of cash available to support ailing companies.
Fidelity manages more than £300 billion in client assets, and according to Richards, many businesses will require capital injections to counter the debt they have accumulated during the crisis. And the sheer size of this outstanding debt will be so large that much of it is likely to be either written off or remain sitting on balance sheets, where it will have a “depressing” effect. “If you don’t want that drag from the overhang to depress the recovery, you have to think about the plan to recapitalise. The [fund] industry can support a high proportion of that, but I don’t think it can do all of that recapitalisation,” Richards told the Financial Times. She advocates, therefore, for businesses to focus on ensuring they have access to as many pools of capital as possible.
But hope is not lost. There are increasing signs that companies are starting to show some resilience as economic conditions gradually begin to improve. According to financial-data analytics firm Credit Benchmark—which polls the forward-looking credit opinions for the industrial companies of the United States, the United Kingdom and the European Union (EU) every month based on the consensus views of more than 30,000 credit analysts at 40 of the world’s leading financial institutions—data for November shows “yet another month of credit deterioration for UK, EU and US Industrial companies”. However, the analysis does acknowledge that each region “showed notable improvement in the severity of the trend”. According to November’s report, UK industrial companies “have entered a sixth consecutive month of net credit deterioration, but the severity has lessened, and the overall position is the best it has been since March—before COVID had begun to majorly impact the global economy”. EU industrials, meanwhile, “have not seen a month of net credit improvement since last December—but unlike their UK and US peers, deterioration has been milder and more consistent”. And US industrials “have seen the biggest improvement in their collective credit quality this month vs. their UK and EU peers”.
A number of countries also implemented laws in 2020 that temporarily prevented insolvency proceedings or declared as inadmissible in court those bankruptcies of firms that were unable to repay their debt obligations, including Belgium, Italy and Spain. Other countries, such as Singapore and Australia, also raised their debt thresholds for companies to be declared bankrupt. However, many of those regulations have either expired recently or will have expired by the end of 2020. And perhaps even more concerning is that a number of major countries did not enact changes to their insolvency laws in response to the COVID crisis, including the US, the UK, the Netherlands, Sweden, Denmark and Ireland. As such, 2021 could see a sizeable wave of insolvencies materialise as a modest economic recovery fails to offset the debt accumulation of indebted companies, particularly in that latter group of countries.
But as is the case with all COVID-related outlooks, much depends on the nature and speed of the recovery during the coming months and years. According to a June working paper from US global policy think tank RAND Corporation, there is an exceptional risk of corporate default in the US, a country responsible for owing almost half of the world’s corporate debt. Under modest levels of social-distancing and economic losses, the study estimated “high levels of average corporate default risk”, but as social-distancing measures and economic contractions persist, levels of corporate-default risk were expected to “exceed those of the 2008 financial crisis”. And under the harshest scenarios of prolonged strict interventions, RAND estimated “exceptional levels of corporate default risk ranging from…double to triple those witness[ed] during the 2008 financial crisis”. That said, the paper did acknowledge that credit-market interventions may prevent the worst of the default-risk scenarios by extending credit access to firms on the brink of insolvency.