Speech

Corporates After COVID: Risks, Recovery, and Restructuring

April 22, 2021

Good morning, ladies and gentlemen. It’s a pleasure to join you for this panel discussion on corporate debt restructuring, and I would like to thank Carmen Reinhart for inviting me to participate.

The outlook for the corporate sector has taken on increasing relevance around the globe, following the massive shock that countries experienced as a result of the COVID-19 pandemic. Why is this the case?

As we outlined in the IMF’s Global Financial Stability Report (our “GFSR”) in October 2019 — before COVID-19 even existed — the global non-financial corporate sector was already facing high vulnerabilities because of their rising debt burdens. Easy financial conditions over the previous decade had extended the corporate credit cycle. Firms took on larger amounts of debt, and they increasingly used it for financial risk-taking, to fund corporate payouts to investors and for mergers and acquisitions. In addition, global credit increasingly flowed to riskier borrowers. By the end of 2019, nonfinancial corporate sector debt had risen — in both Advanced Economies and Emerging Markets — to a historical high, reaching 91 percent of GDP.

We undertook a study of corporate vulnerability in eight large economies as part of that October 2019 GFSR. We envisioned a material economic slowdown scenario, half as severe as the global financial crisis. We found that corporate debt-at-risk — that is, debt owed by firms that cannot cover their interest expenses with their earnings — would rise to nearly 40 percent of total corporate debt in major economies by 2021. That figure was above the level following the global financial crisis.

That turned out to be a prescient analysis, helping us understand the vulnerabilities of the corporate sector — even before the COVID-19 pandemic radically changed the landscape.

Amid the pandemic, the global corporate sector was hit hard, squeezing cash flows. Firms responded by cutting employment, delaying capital investment, and running down their cash buffers. Moreover, they also drew on their existing credit lines from banks, and those corporations that had market access stepped up bond issuance.

Extraordinary policy support drastically eased financial conditions. Central banks and governments also provided direct funding support programs. In addition, they facilitated increased corporate borrowing through government loan guarantees, as well as taking other measures to support firms and banks.

As detailed in our latest edition of the GFSR, issued just two weeks ago, global nonfinancial corporate debt increased by a further 11-and-a-half percentage points of GDP between the end of 2019 and the third quarter of 2020. Sharp declines in output, particularly in Emerging Markets, contributed to the increase in debt-to-GDP ratios. The level of debt rose even further during the COVID-19 crisis.

Moreover, corporations are now facing increased stress, with notable differences across sectors and across firm sizes. Liquidity stress — the ability of a firm to pay off short-term financial obligations, without raising additional external financing — is high at small firms in most sectors and across countries. Solvency stress — the ability of a company to meet its short- and long-term financial obligations — is high at small, mid-sized, and even large firms in the sectors most affected by COVID-19.

The buildup in corporate leverage and stress raise several challenging questions for policymakers.

• What are the financial-stability risks for the banking sector posed by the rise in corporate-sector vulnerabilities? Looking ahead: Do banks have the capacity to continue lending to support robust growth?
• Given stretched fiscal resources in many countries, should governments continue to provide support to firms? If so: In what form, for how long, and to which firms?
• What are the tradeoffs between (in the short term) maintaining easy financial conditions to nurture the recovery of growth, and (in the longer term) the risks that even higher corporate debt could pose for vulnerabilities to future growth?
• What is the best way to facilitate corporate debt restructuring to reduce debt overhangs?

To shed light on the first question: Our GFSR of October 2020 undertook an analysis of the impact of corporate stress on banks’ capital ratios with a “global stress test.” The analysis was carried out for 29 systemically important jurisdictions using a sample of 350 banks, accounting for 73 percent of global banking assets. Loan-loss provisions were estimated based on overall exposures. The analysis found that the COVID-19 shock reduced banks’ capital by around $400 billion — although, in the absence of policy support (including government loan guarantees and capital adequacy policies), the shock to capital would have been higher, at around $600 billion. Nonetheless, more than 90 percent of banks in the analysis were estimated to remain above statutory minimum capital levels through 2022.

Most banks will probably remain adequately capitalized, but recent surveys indicate that banks may have become more reluctant to lend as the COVID-19 pandemic has dragged on. In part, this appears to reflect the expected phasing-out of lending-support policies. Also, concern about credit quality could adversely impact banks’ capital positions. This points to the need to maintain borrower-support policy measures until the economic recovery is well entrenched.

Supporting all stressed debtors, however, is neither feasible nor desirable. Actions should be carefully calibrated to mitigate the threats to financial stability from the pandemic shock, but also to allow the resources of non-viable enterprises to be recycled back into the productive economy. Achieving this balance involves replacing the blanket support measures that many countries have deployed. Instead, policymakers should consider adopting targeted and time-bound measures to avoid adverse impacts on economic and fiscal health; to promote private investment and credit discipline; and to facilitate enterprise restructuring and fair burden-sharing when necessary.

Policymakers also face a tradeoff in deciding how long to provide support. Maintaining support for too long could exacerbate the buildup of corporate leverage. Historically, a rapid accumulation or high level of non-financial-sector leverage has often preceded financial and economic downturns. Indeed, a growth-at-risk analysis in our latest GFSR shows that a 10-percentage-point acceleration in nonfinancial corporate leverage buildup is associated with an increase in downside risks to economic growth, in the near term, of about 1 percentage point.

Policymakers thus need to be mindful of the financial-stability risks stemming from high leverage in the post–COVID-19 environment. They should be ready to tighten macroprudential policies as the recovery takes hold. Targeted macroprudential policies that “lean against the wind” — that is, that mitigate the adverse effects of loose financial conditions — can help contain or even reverse leverage buildups, and thereby reducing risks to future financial stability.

The appropriate timing for the deployment of macroprudential tools should be country-specific — depending on the pace of recovery, postcrisis vulnerabilities, and the policy toolkit available. However, given the possible lags between activation and full impact, policymakers should take early action to tighten selected macroprudential tools to address rising financial vulnerabilities.

To help determine which firms should seek market funding, receive government support, or be restructured or liquidated, our latest GFSR proposes a “decision tree” that identifies firms according to liquidity, solvency, and viability risks. (By “viability risks,” we mean identifying firms that are unlikely to be profitable within a three-year time horizon.)

• Firms with low liquidity and solvency risks are likely to have market access. They should be encouraged to take advantage of favorable market conditions to repair and adjust their balance sheets.
• Firms facing high liquidity or solvency risk, and high viability risk, should be restructured or liquidated.
• Viable firms with high liquidity risk should be encouraged to access market funding. Those with limited market access could be provided targeted liquidity support — for example, through loan-guarantee programs.
• Viable firms that face high solvency risk should be encouraged to raise equity. If they lack market access, policymakers could consider equity-like support, accompanied by appropriate administrative controls, transparency, accountability, conditionality, and a clear exit strategy.

Applying this “decision tree” to almost 20,000 firms in Advanced and Emerging Market economies, our latest GFSR found that the share of debt at firms with high viability risk is notable particularly for small corporates.

Finally: What are some key considerations for facilitating corporate debt restructuring and the resolution of non-performing corporate-sector loans on banks’ balance sheets? Some loans to firms will not recover. That will result in higher non-performing loan (NPL) levels, even with a strong economic recovery. Addressing that factor in a coherent approach is important, because high NPLs can “zombify” a business line or an entire bank; can create negative feedback loops; and can erode the confidence of bank investors and deposit-holders.

Enhanced prudential regulation and intensive supervision of banks is needed to ensure consistent NPL reporting and prudent provisioning. Developing markets for NPLs — and attracting third-party firms specializing in NPL investments and servicing platforms — can play a key role. This can enable banks to rapidly build comprehensive and effective operational capacity through outsourcing of recovery operations; facilitate disposal of NPLs in the open market; and attract fresh capital. State-sponsored asset-management companies (AMCs) can help absorb NPLs from banks during systemic crises but they must be carefully designed. Experience with publicly owned and publicly managed AMCs has been mixed. Their impact depends critically on the fine details of their design.

Equally important, is having a robust legal framework for insolvencies. That framework must enable the timely, transparent, and predictable recovery of claims through enforcement and insolvency proceedings, while protecting value for all concerned parties. Special out-of-court solutions can facilitate the effective and timely financial and operational restructuring of firms by private creditors. Standardized restructuring solutions can offer simple, less precise and less costly results. Simplified court proceedings can reduce the cost and use of judicial resources for micro and small enterprises.

In sum: The impact of the COVID-19 shock on nonfinancial corporations has brought a host of issues to the forefront of policymakers’ agendas. Corporate leverage and stress have continued to rise, reinforcing the nexus between firms and banks. Continuing policy support is needed — but there are trade-offs that call for attention to financial-stability risks; better targeting of support in the near term; and facilitating the repair of corporate balance sheets over the medium term.

Policymakers confront a wide-ranging agenda ahead. But by taking timely and forceful action, well-calibrated steps can help open the way toward renewed economic growth with stronger prospects for financial stability.

Thank you very much.