Dealing with corporate distress, repair, and reallocation

1. Introduction

The economic response to the coronavirus pandemic has varied across the world, depending on whether countries have had fiscal resources and monetary room to address its challenges or not. Typically, in the first phase, resource-rich countries focus on containment. They use regional lockdowns and limits on certain commercial activities (such as hospitality and public transport) to bring the virus caseload down to the point where testing, tracking, and isolation can contain further spread. During this phase, governments (often together with central banks) have provided relief to households and firms to enable them to survive the period of constrained economic activity.

When the virus spread has been contained, the second phase, rebound, commences. Restrictions are lifted, mobility picks up, and economic activity rebounds, if not across all sectors, at least quite substantially. No large country thus far (with perhaps the exception of China) has been sufficiently free of the virus and subsequent waves of reinfection to embark fully on the third phase – dealing with corporate distress. This paper will focus on the need for such a phase in the economic response plan and the desirability of preparing for it. It will be especially important for resource-poor economies that have not been able to provide significant relief to households and small enterprises, and where economic scarring is likely to be extensive.

2. The initial phase of the economic response

Given the Chinese experience with containing the first wave of the virus, a number of countries may have expected they would have similar outcomes: a short period of several weeks of severe lockdown, followed by a strong and increasingly widespread rebound of economic activity, spreading from manufacturing to services. The reality in most countries outside a few North Asian countries and Australia/New Zealand has been quite different. A number of countries have experienced prolonged first waves, where lockdowns have been ineffective. While most countries managed to bring down the virus caseload to a relatively low number, it has not been sufficiently low in many cases for them to be able to implement testing, tracking, and isolation in full measure. As a result, the public has not had sufficient confidence to be able to patronize high contact services, such as shopping malls, football matches or cruises, with full gusto. And now we are seeing considerably more infectious second waves emerge across the world.

The very generous and untargeted support governments and central banks in industrial countries provided in the initial days of the fight against the virus is therefore proving insufficient. There are widespread demands to extend this support through the second and possible third waves till (hopefully) vaccinations fully contain the virus. In many emerging markets and developing countries, even the initial level of support has not been available because of limited government fiscal resources. Households and small and medium enterprises have had to muddle through as best as they can by borrowing or by selling assets – in India, gold loans, obtained when a household mortgages its gold jewellery, have been an important source of credit growth during the pandemic.

Initially, the costs of the support provided to firms were commensurate with the avoided disruption – why force a firm into bankruptcy or to liquidate if it could be kept alive for a couple of months and would flourish again in the rebound? Moreover, to the extent that the firm retained its employees, the state would avoid the costs of paying unemployment support. Early evidence on the Paycheck Protection Program in the United States (see Granja, Makridis, Yannelis, & Zweik (2020)) suggests that the support was helpful in increasing the survival rate of small and medium businesses, but did not seem to prevent rises in unemployment. Put differently, more firms survived, but the cost to the government was not insubstantial as firms rationalized their workforces in order to survive. Moreover, it seems that some of the government support leaked out to make private claimants whole. Chodorow-Reich, Darmouni, Luck, & Plosser (2020) find that Small and Medium enterprises (SMEs) that received PPP loans reduced their non-PPP bank borrowing in 2020Q2 by between 53 and 125 percent of the amount of their PPP funds.

In January 2021 when this paper is being written, the virus looks like it will not be contained for a few quarters at the very least. Emerging markets and developing countries have spent only a fraction of what industrial countries have spent (by October 2020, the IMF Fiscal Monitor suggests an average additional fiscal spending of around 4 percent of GDP in emerging markets and 1.5 percent of GDP in low-income countries, compared to around 10 percent in advanced economies), and seem to believe they cannot afford more.1 Advanced economies, however, seem to be willing to spend what it takes. How much can they spend?

2.1. Support everyone: we have the debt capacity!

The United States ran a fiscal deficit of $3.1 trillion in 2020. The new packages proposed by the Biden administration suggest additional pandemic-related spending of similar magnitudes in 2021. The United States is nowhere near the highest spending government thus far as a fraction of GDP (according to the IMF, by September 2020 Japan had offered more in credit guarantees and equity support than the United States while spending about as much in fiscal terms, while New Zealand spent significantly more in fiscal terms).2 Sovereign debt levels now exceed GDP in many developed countries and, on average, debt as a share of GDP is approaching post-World War II highs.3

Nonetheless, according to Blanchard (2019) and others, advanced economies can afford to take on much more debt, given the low level of interest rates. Calculations using International Monetary Fund data show that in the two decades before the pandemic, sovereign interest payments in these countries fell from over 3% of GDP to about 2%, even though debt-to-GDP ratios increased by more than 20 percentage points. Moreover, with much of the newly issued sovereign debt now paying negative interest rates, additional borrowing stands to reduce interest expenses even more.

In this strange world of ultra-low interest rates, what limits are there on government borrowing? According to advocates of Modern Monetary Theory (MMT), there are few, at least for countries that issue debt in their own currency and have spare productive capacity. After all, the central bank can simply print money to pay off maturing debt, and this should not result in inflation as long as there is sizable unemployment. No wonder MMT has become the go-to idea for politicians advocating government spending to alleviate every problem.

Of course, any “theory” that promises a free lunch through monetary prestidigitation should be approached with skepticism. To see why, suppose we were in a normal environment with positive interest rates. The central bank could decide to print money to buy government bonds, and the government could then spend that money by transferring it to citizens. As a practical matter, however, there is only so much cash that someone will hold in her purse. If she already had enough on hand before the central bank started printing money, she will deposit the government transfer in her bank account, and her bank will deposit all the cash it has accumulated in its reserve account with the central bank.

Ultimately, the central bank will have bought government bonds by issuing reserves to commercial banks, which will then want to be paid interest on those excess reserves. The government could just as soon have issued Treasury bills directly to commercial banks. The interest cost would be more or less the same. The only difference is that there would be no appearance of a free lunch.

In today's abnormal environment, the central bank can finance the purchase of government bonds by issuing zero-interest-paying reserves to commercial banks, which in turn are willing to hold large quantities of such highly liquid reserves. That sounds like MMT nirvana. Yet, again, the government could just as soon issue Treasury bills paying zero interest to commercial banks. If commercial banks do not balk at holding vast quantities of claims on the central bank (reserves), they should not balk at holding vast quantities of claims directly on the government, of which the central bank is a subsidiary.

In other words, the monetary financing advocated by MMT is just smoke and mirrors. Yes, the government can avoid short-term disruptions in money markets by financing via the central bank. Over the medium term, however, this approach does not allow it to borrow any more than it could have by financing directly. In fact, if long-term interest rates are also low or negative, it is far better for the government to lock in those rates by issuing long-term debt directly in the markets, bypassing the central bank altogether.

That brings us back to the initial question of how much debt a government can issue. It is not enough for a government to ensure that it can afford to make its interest payments; it also must show that it and its successors can repay the principal. Some readers will protest that a government does not need to repay debt, because it can issue new debt to repay maturing debt. But investors will buy that new debt only if they are confident that the government can repay all its debt from its prospective revenues. Many an emerging market has faced a debt “sudden stop” way before it reached full employment, triggered by evaporating market confidence in its ability to roll over debt. Often, that confidence vanishes when the politics of the country becomes dysfunctional, and investors sense that fiscal responsibility will be jettisoned in favor of competitive populism. In this light, a not inconsiderable concern is that the political consensus in some developed countries has been fracturing in recent years.

In sum, industrial country governments can probably issue more debt at this point, especially given the low level of interest rates. However, in countries where politics are becoming more dysfunctional, the government should worry not just about debt service costs but also about debt rollover. It is probably best that countries lock in low current financing rates by eschewing monetary financing, and instead issuing long maturities to the market. At any rate, it is probably unwise even for fiscally healthy countries to assume there are no limits on financing spending, even at a time when interest rates are at rock bottom. This is therefore a reason to consider the efficacy of spending.

2.2. Support everyone: It is not their fault!

Are such arguments trumped, however, by a fairness argument for more spending? Consider a country that has plenty of borrowing capacity. Should it support all firms in trouble and help them survive till demand revives, ignoring considerations of efficiency? Most would argue that a role of the government is to provide a safety net so that citizens are protected against market-induced or nature-induced disasters. Yet, such an argument applies best to individuals, not businesses. While the government in a developed country has the responsibility to ensure that no resident goes hungry, homeless, or without medical care, it has no obligation to protect their businesses or their wealth from every loss.

Governments do provide at least two forms of implicit insurance to firms. First, when a community is hit by a localized flood or an earthquake, uninsured local firms are often helped to get back on their feet through grants or cheap loans. The government acts like a national insurer of last resort, providing help to all in affected localities, funded by taxes paid by everyone else. People in unaffected parts of the country pay these higher taxes willingly because they know that their community would receive the same treatment if they were hit. Such “cross-country” insurance comes from the bonds of solidarity implicit in being part of the same country.

Similarly, over the business cycle, the government might engage in stimulus spending during the trough of activity, only to recoup the spending through higher tax revenues as the economy recovers. Once again, the citizen supports government intervention if it is believed to smooth out the business cycle. Think of the government as providing macro-insurance to firms in bad times – which prevents them from shrinking excessively or laying off too many workers – and recovering the costs in good times – it essentially buffers the economy against fluctuations over time. When such policies are well designed, governments try to balance their budgets over the business cycle with counter-cyclical fiscal policies – more stimulus when the economy slows, balanced by more tax revenues when it picks up.

A nation-wide pandemic is not like a localized calamity. The whole nation is hit, and there are no regions that escape. So the government cannot really spread the costs of helping one local region across the untouched rest as a nationwide insurer would. It can spread the costs over time if the pandemic is short in duration – following the same logic as a business cycle downturn. However, if the pandemic is more prolonged, the high costs of unconditional untargeted support will typically not be paid by the cohorts being helped. Even with higher taxes on the rich – a policy that will meet with intense opposition and arguments against growth-stifling austerity – a large share of the accumulated debt will be passed on to future generations.

Of course, it could be argued that in a growing country, no cohort really pays down national debt. Indeed, in the past, such debt was easier to pass on. Because strong growth meant that each successive generation was richer, past debts shrank relative to incomes. Yet today in industrial countries, societal aging, low public investment, and tepid productivity growth all militate against future generations of citizens being much richer than the current ones are. Moreover, those future citizens already have two enormous challenges: supporting social security and medical care for the growing cohorts of the elderly when the public funds dedicated to these entitlements run out, and addressing climate change.

By further limiting future generations’ ability to make public investments, the debt that today's citizens pass on will likely weigh down future incomes, rather than shrink relative to them. And if overall borrowing capacity is depleted today, future generations will be unable to spend as needed if they encounter another “once-in-a-century” catastrophe like the two we have experienced in the last 12 years. Inter-generational fairness should be as important as intra-society fairness for those making decisions today.

In practical terms, this means that the notion that anyone should be made whole again because the pandemic “wasn’t their fault” immediately becomes untenable. With a shock as large as the pandemic, this calculus no longer works; the burden of payment for these transfers inevitably must fall on future generations, who obviously had no responsibility for the pandemic or the response to it. In short, even if a country has the debt capacity to compensate all firms for the losses suffered in the pandemic, it should not. Instead, it should look to support firms only if it makes economic sense, and the benefits through preserving the productive capacity of the economy broadly outweigh the costs.

So, for instance, grants to firms that would survive anyway are unwarranted. They simply bolster the wealth of firm owners. Grants or loans to firms that immediately go to pay their bank also need to be thought through carefully. These are a form of windfall gain to the bank, which would otherwise have to renegotiate down its loan, or reschedule payments. If the bank is healthy and can survive after absorbing such loan losses, then this is a direct transfer to its shareholders. Government support needs to be better targeted towards firms that offer a high public return on the limited resources it has available.

As governments considers support to corporations both in the remaining time while the pandemic rages and after the pandemic ends, a common set of questions arise to guide any form of corporate triage: (1) Which firms are worth supporting from a public perspective? (2) For these, how can the call on public funds be kept at the minimum possible? (3) How can the support be best structured and delivered?

3. Who should be supported?

Politicians would like to avoid choosing whom to support, because choice is fraught with political costs – the anger of those who are left unsupported, or the political fallout if the choices are not totally transparent or turn out to be errors.4 Importantly, the politically attractive choice is not necessarily the best economic choice. For instance, small “Main Street” enterprises, such as restaurants and craft shops, give neighborhoods character and are often what the public identify with and want to support but these enterprises start up and shut down constantly. For the most part, public money should not be used to freeze the current enterprises in place, paying rent, salaries and interest for unused resources. It might be better to taper off public support instead. Some enterprises will survive by renegotiating terms with landlords and banks. Others will not. Bar staff who lose their jobs should get unemployment benefits while the venerable pub they work for should be shuttered. It can reopen, rehiring its workers when social distancing eventually ends or, if demand has changed by then, repurpose itself as an e-sports parlor. As the lockdowns stretch on, it is more important to protect the worker not the job, especially if the job is easily recreated.

There are a couple of caveats to the arguments just made. First, in poor and disadvantaged neighborhoods, not only is it hard for businesses, even tiny ones, to start up, existing businesses are sometimes central to the social and economic ties that hold the (already weak) community together. The social cost of letting such businesses fail is likely higher. Therefore, greater weight should be placed by public authorities on protecting any business in disadvantaged communities. Second, the argument – that small businesses can be let go because others will start up to replace them at the appropriate time – relies on entry being easy and the entrants having adequate access to finance. In countries where entry regulation makes entry difficult, or where private financing is tight, authorities can sensibly follow a policy of leaving small businesses to fend for themselves only if they simultaneously work on liberalizing entry and easing access to financing for when the economy is set to rebound.

Medium and large companies have more organizational capital than small ones. Embedded in them are valuable, complex relationships between stakeholders, such as employees and suppliers, built over years. Once such a firm is closed down, these relationships may not be recreated easily or quickly by an entrant, even if critical to its smooth operation. The firm's productive capacity may be severely damaged even if it survives but is financially stressed for a considerable period of time. For instance, suppliers may want upfront payment, and given the tight funds situation, the firm may not be able to keep up production thus losing on revenues. It may not be able to maintain equipment adequately, or make needed investments, including in customer service. It may also lose its best employees, as they are lured by better opportunities elsewhere. Governments may have a role in reducing these costs of financial distress.

To start with, however, the government has to figure out whether the firm they seek to help has a viable business model – some may not for a long while after the pandemic ends. While holiday travel may pick up rapidly as people strive to compensate for months of being cooped up at home, it is hard to imagine that business executives will find the need to travel as much to meet each other post-pandemic, given the stigma of using video calling to make business calls has been eliminated by the pandemic. Of course, other reasons to travel will emerge over time, but firms such as airlines or hotel chains that depend on business travel may have to shrink for a while, or even close. So will many a department store whose clientele has learnt to buy online. It does not make sense to spend public money to keep such firms frozen in time – even if such support is made contingent on these firms retaining employees. Far cheaper for the government to support laid-off workers through unemployment insurance than to pay employers to retain them indefinitely when their work has clearly disappeared. All that does is simply postpone the needed adjustment.

The bottom line is that some targeting of support is warranted even in the relief stage as the pandemic drags on – in particular, governments should not spend money on small or failing firms whose activities can easily be recreated, or come in the way of the needed restructuring of firms in sectors whose business viability is doubtful. Paying firms to keep workers on that they do not need may be particularly costly and ineffective.

Of course, targeting is hard while the pandemic is still on and the pressure to keep the fiscal taps open is strong. It may well be political suicide for governments in democracies to help larger firms while letting small firms go under. Perhaps in the interests of preserving democratic stability, some nod to political imperatives will be warranted.

So it may well be that relief efforts will take the form of weakly targeted grants, as well as partial or full guaranties or interest subsidies on loans until the pandemic abates fully. At that time, however, in industrial countries there may be more willingness to target support better. It is also the time when emerging markets will have to take stock of the damage that has been done to firms in the economy because of their inability to offer significant support during the pandemic. This is the phase when balance sheets are repaired and productive assets reallocated.

4. Minimizing the call on the public purse

Most medium and large firms with a viable business model post-pandemic will get private financing that allows them to survive. An important exception is when they are heavily indebted. In normal times, firms typically become excessively indebted when they have an unprofitable or unviable business model and they borrow to stay in business. Excessive leverage is thus a sign of unviability. During the pandemic, however, firms may have built up debt because lockdowns and social distancing depressed their revenues without altering their costs. These businesses may be perfectly viable in the post-pandemic world.

What such firms first need is a more suitable capital structure – that typically means renegotiating debt, rents, and other claims down, either in an out-of-court-restructuring, or after filing for bankruptcy. Unlike small firms, the value of medium and large firms is not excessively dissipated in bankruptcy reorganization. Over 95 percent of firms below $ 1 million in liabilities are liquidated when they file versus around 20 percent for firms with over $ 1 billion in liabilities (Greenwood, Iverson, & Thesmar, 2020). This is perhaps why Wang, Yang, Iverson, and Kluender (2020) find that Chapter 11 bankruptcy filings by large firms (which they define as firms with over $ 50 million in assets) in the United States were up 200 percent in the period January–August 2020 relative to a similar period the previous year, while Chapter 7 filings for small firms declined.

The government can help this process. Importantly, it can make the bankruptcy process easier and reduce any bias toward liquidation – the Chapter 11 process for large firms in the United States, which tends to rehabilitate most large firms that file as going concerns, offers a starting template. In February 2020, the United States introduced a new Subchapter V filing for SMEs with less than $7.5 million in liabilities. As Greenwood et al. (2020) argue, the goal of this new process is to preserve owners’ equity by giving the owners more power; First, unsecured debt loses priority to equity. Second, the court has the power to confirm a plan without a formal vote of creditors. This has the effect of making creditors weaker than in the traditional Chapter 11 bankruptcy, allowing more firms to emerge as going concerns. The implicit bias towards owners and away from liquidation is appropriate in situations where a SME has excessive debt because of unforeseeable events beyond its control rather than because of mismanagement.

One problem with pushing many firms into bankruptcy to restructure their debts is that it may overwhelm a country's existing bankruptcy system. An additional benefit of a more owner-friendly bankruptcy process is that it incentivizes creditors to try and restructure out of court in a pre-packaged bankruptcy. Participants may then use the court merely to give the negotiated package legal status, rather than using its time to supervise the long-drawn-out process of renegotiation. Of course, the shadow of a possible filing in the bankruptcy court, in case negotiations break down, guides the terms that are negotiated in the out-of-court restructuring.

More generally, corporate distress should not be allowed to fester, so any restructuring of debts should be done as swiftly as possible. Unaddressed or excessively delayed, distress can spread. If many shops on Main Street are shuttered, shopping there becomes unattractive, and the remaining shops will lose business. At the same time, indefinite taxpayer support to unviable businesses can create excess competition for the possibly shrunken post-pandemic demand that will erode the health of viable competitors. As Caballero, Hoshi, and Kashyap (2008) show in their study of post-crash Japan, the industries dominated by unviable “zombies”, kept alive by banks unwilling to pull the plug, exhibited more depressed job creation and destruction, and lower productivity. Jordà, Kornejew, Schularick, and Taylor (2020) suggest such zombification is more likely in countries with weak systems for financial restructuring. These conditions are more likely in emerging markets, and policymakers there should review their bankruptcy and restructuring procedures to ensure they can be made to work effectively once moratoria and forbearance end.

5. Structuring and delivering government support

For small and medium enterprises that have moderate indebtedness but have little access to borrowing from a risk averse financial system, the government can offer lending support. In the interest of better targeting, however, it should insist on greater private sector involvement and risk sharing. For example, it can steadily reduce the extent to which loans are guaranteed – by forcing lenders to share more of the first loss. This will coax private sector lenders into assessing the underlying viability and creditworthiness of the borrower. As the G30 Report on Reviving and Restructuring the Corporate Sector (2020) suggests, governments could also pay for only a fraction of the losses on a credit portfolio rather than guaranteeing each individual loan; furthermore, they could require government-supported loans be tied to the borrower's evolving credit risk (also known as performance pricing) so that borrowers have incentives to improve their own credit quality.

For large indebted firms, the government could support the debt restructuring process post-pandemic with selective infusions of equity. Some governments have sovereign funds that habitually invest in private sector firms (for example, GIC in Singapore, and ADIA in Abu Dhabi). Such funds have experience in deciding where to infuse equity, what write-downs to demand from other creditors, and what price to pay for the equity. Clever structuring would give the government some upside stake in case the supported firm flourishes, and some downside protection in case the firm fails.

Where no arm of the government has experience structuring such deals, the government should look for expertise elsewhere in the private sector. After the global financial crisis, countries like the United States created public-private partnerships with financial firms (such as the 2009 Public-Private Investment Program) to infuse fairly-priced equity into private firms. The experience of those partnerships could be useful in designing new structures.

Takeovers of weak firms by strong firms are also a way to resolve distress. So long as such takeovers do not impinge seriously on industry competition, they should be encouraged. The government can speed its scrutiny of such proposals, and reduce any tax burden such transactions create. Finally, some countries will be more open to nationalization than others. While recognizing that government ownership can affect the longer term productivity of an enterprise, some countries may nationalize some firms temporarily, while others may create public-sector holding company structures.

In sum, starting with a clear definition of their priorities and the resource envelope they have, authorities will have to tailor policies that make best use of their institutional capabilities while respecting public views on intervention. There cannot, therefore, be a one-size-fits-all approach.

6. Concluding remarks: what about developing countries?

Governments will set their economies back on the growth track if they can devote resources to corporate relief, repair, and recovery. Developed countries can do so, but some developing countries will have very few resources and a commensurately large repair job on their hands because they have not been able to spend on relief. To expand spendable public resources, the poorest countries should negotiate lower sovereign payments to external creditors, including private ones. The rest should expand sovereign borrowing capacity by committing to return to fiscal viability over the medium term, for instance via legislated debt reduction targets. They should shelve unnecessary spending and, where feasible, sell state-owned assets. The resources thus raised should partly be used in corporate repair.

Corporate and bank capital will be depleted as losses are realized. So limits on domestic investors, such as pension funds, investing in such capital should be relaxed within broad prudential norms. Foreign investment in domestic risk capital should also be welcomed. If viable firms still need capital, especially in the crucial financial sector, governments should provide it on fair terms. This is a high value use of funds.

Repair will do little, though, without a rapid recovery of demand. With fiscal resources limited, developing country governments will be unable to stimulate much. So recovery will depend on external demand, be it from exports, investment or tourism. Yes, the poorest countries will benefit from debt relief, while others will need multilateral loans. But most of all they will need uninterrupted trade and investment flows to help them build on domestic demand.

Out of self-interest, the world's more industrialized countries need to spare a thought for the rest – unfortunately, this has not happened with the distribution of vaccines. What happens elsewhere will not stay there. By weakening global demand, a decade of lost growth in the developing world would certainly slow developed country growth. Mass long-term unemployment in the developing world will also prompt mass emigration. Sagacious leaders in industrial countries should persuade less-farsighted colleagues that closing borders to trade and investment will only subject them to endless flotillas and caravans of the desperate. Sharing growth is in everyone's interest.