The huge amount of borrowing undertaken by firms in the last three months is reassuring in the sense that businesses are getting the cash they need to make ends meet. But some firms won’t be able to cope with the higher debt burden. And those that can will probably pare back their investment plans.
- The huge amount of borrowing undertaken by firms in the last three months is reassuring in the sense that businesses are getting the cash they need to make ends meet. But some firms won’t be able to cope with the higher debt burden. And those that can will probably pare back their investment plans.
- Business borrowing shot up to unprecedented levels in March and April as firms tried to build up enough cash to see them through the cratering in revenue due to the coronavirus crisis. In just two months firms borrowed £60bn from banks and the capital markets, double the amount they borrowed in all of 2019. And we know that firms borrowed at least a further £33bn through government schemes in May. (See Chart 1.)
- All told, firms have borrowed just over £90bn so far this year, raising total corporate debt by 5%. When paired with the 12% y/y fall in GDP that we are forecasting this year, the corporate debt-to-GDP ratio will rise from 79% in 2019 to about 95% in 2020. (See Chart 2.) And that is a lower bound given many businesses probably borrowed outside of government schemes in May and continued to rely on borrowing to make ends meet in June.
- In one sense, the vast increase in borrowing is a reassuring sign that firms are able and choosing to borrow to see them through the crisis. And in aggregate the debt looks manageable. Very low interest rates mean that debt interest payments were just 7% of firms’ operating surplus last year, down from 15-25% in the 2000s. (See Chart 2 again.)
- But when broken down by sector and firm size, it becomes apparent that some firms will struggle to shoulder the additional debt. The bars on Chart 3 show the increase in outstanding bank loans to firms in various sectors between February and April. The largest increase in borrowing has been in the manufacturing, transport & communication, and utilities sectors. The increase in lending to the recreation and hospitality sectors has been surprisingly small. But that may be because small firms didn’t have access to government support until May. So these five sectors are the most vulnerable.
- The diamonds on Chart 3 show the average interest cover ratio (ICR) of UK-listed firms in each sector – the number of times operating profits cover interest expenses. When it falls below 2.5, firms are thought to be at a high risk of repayment difficulties. With the exception of utilities, some comfort can be taken from the fact that the average ICR is above 2.5 in the five sectors highlighted. But the fall in profits due to the crisis will probably cause the metric to fall to levels consistent with repayment difficulties in more sectors.
- So far the data show that the value of loans to large firms increased by 14.5% between February and April and by just 1.6% to SMEs. But rather than suggesting SMEs didn’t need the cash, that was because they couldn’t access it. The Bounce Back Loan Scheme (BBLS) launched in May addressed this issue. £24bn of loans were issued to 782,246 companies through the scheme in the first month, which will push up loans to SMEs by 16%. (See Chart 4.) The reluctance of banks to lend to SMEs before the government guaranteed 100% of the debt with the BBLS is a worrying sign that banks are concerned about the creditworthiness of smaller firms. A Bank of England analysis found that many companies were “highly leveraged, had low credit ratings or were unprofitable before the Covid-19 shock”.
- So for the most financially vulnerable small firms and those in sectors like recreation, hospitality, transport & communication and utilities, the additional debt may only prolong the inevitable. This suggests we are right to expect a wave of around 110,000 business insolvencies, a similar number to that after the global financial crisis. (See here.) As a result, many of the loans issued through government schemes, and the BBLS in particular, will eventually be added to the fiscal costs of the crisis.
- Even where it does not lead to bankruptcy, the higher debt will hold back the recovery somewhat. Higher interest payments and refinancing risk will make those firms that survive more risk averse, causing them to be more reluctant to undertake big investment projects.
- Overall, firms taking on debt to see them through the crisis is the lesser of two evils. Some companies will be unable to shoulder the additional burden and it will make those that can cope more reluctant to invest. But that is a reasonable price to pay to ensure that most firms survive the crisis, and keep the supply potential of the economy largely intact.
Chart 1: Net Corporate Borrowing (£bn per month)
Chart 2: Private Non-Fin. Bus. Debt & Interest Expenses
Sources: BoE, Capital Economics, Refinitiv, HMT
Sources: ONS, Refinitiv, Capital Economics
Chart 3: Interest Cover Ratios & Borrowing During the Coronavirus Crisis
Chart 4: Outstanding Loans by Business Size (£bn)
Sources: Refinitiv, BoE, Capital Economics
Sources: Refinitiv, BoE, HMT, Capital Economics
Andrew Wishart, UK Economist, +44 7427 682 411, firstname.lastname@example.org