Paying it Forward

Without action, debt could drag down the recovery

This paper considers how the exogenous shock of the pandemic has affected firm balance sheets as we emerge from lockdown—and what it means for investment, jobs and growth as we enter the recovery.

At the height of the lockdown, in the worst-affected industries over 80% of businesses were forced to close. This meant lost revenue and so losses that affect their ability to function. The unprecedented level of taxpayer support prevented a catastrophe. Without it, we estimate that 12% of firms would have failed due to the lost revenues causing a cash flow crisis. This would have resulted in an additional 5 million people unemployed, or a headline unemployment rate of 18.8%, the highest level since before the Second World War.

Government support means that a cash flow crisis has not been realised. However, while a loan provides immediate and needed cash it comes at the cost of a long-term liability. This is in principle a sound instinct—taxpayers should expect to be repaid for taking on private investors’ risk. But in practice, the rapid growth of firm-level debt creates numerous longer-term problems.

• The additional debt will push some firms’ net asset position into technical insolvency, meaning they may not be able to access further support. This accounts for 4.3% of firms in our sample employing an estimated 1.8 million workers.
• If firms remain technically solvent the additional debt they are forced to take on could lead to zombification. Zombie firms are firms laden with so much debt that their profits only just cover their debt interest payments—or in some cases, they can not cover them at all. As of March 2020, one in every five firms (21%) was a zombie firm.

These results are the result of modelling financial outcomes up to the end of August. The implicit assumption is that these are the conclusions that would arise from the demand side of the economy recovering immediately from now. Every day that spending remains below pre-crisis levels these numbers will worsen.

Another factor that should give policymakers further pause is the heterogeneity within the economy. Some industries have made it through the crisis relatively unscathed. But other industries have faced an unprecedented financial challenge.

The Hospitality sector and the Arts, Entertainment and Recreation sector collectively account for over 10% of employment in the UK. Without support, 35% of firms in these sectors would have faced financial difficulties. Taking on additional debt means 13-19% of these firms have either failed or become accounting insolvent, and using a broad definition we estimate 40% of firms in these industries are now zombies.

This rise in zombie firms will have an knock-on effect across the economy, with our estimates suggesting that without further action business investment will be reduced by £42 billion a year, slower employment growth that could mean over 400,000 fewer jobs created in a recovery that takes over twice as long, and lower productivity leading to £41 billion of lost growth over 5 years—more than £500 per person.

How to fix it

A number of potential solutions have been theorised. For instance, the idea that the Government should convert some or all of the debt issued to businesses through the CBILS and BBLS schemes into equity. Or to restructure or partially forgive debts that have gone bad.

While these proposals have merit there are nonetheless well-placed concerns around their practical utility, the dynamic incentive structures and moral hazard risks inherent in such schemes among others.

Instead, we suggest a New Start scheme that allows loans to be paid back through taxes on profits would provide the economic flexibility and administrative efficiency needed to overcome this crisis, maximising taxpayer value for money at the same time.