Avoiding economic scars

Bank lending and government support has provided a crucial lifeline for UK businesses but should the government help everyone keep their jobs? Is every business worth saving?

Hélène Rey, Lord Raj Bagri Professor of Economics, and Paolo Surico, Professor of Economics at London Business School, asked how the government might chart a path to a post-pandemic economy as part of the Wheeler Institute’s UK economy webinar series.

Together they mapped areas where the government can tailor its response to greater effect and what the pitfalls might be if we simply try to recreate the economy as it was.

Using his own research, Professor Surico began by painting a picture of conditions for startups when cashflow and access to finance is all but cut off.

This is important because, like many developed economies, the UK is reliant on startups to create jobs. These are young and highly levered businesses. Professor Surico has found that 75% of small and medium enterprise loans in the UK are secured against property. In 99% of these cases the loan is guaranteed using the director’s home as securitisation. This number is only one third for older and less leveraged firms.

Another way of obtaining loans from banks has been cashflows. Small firms with low value assets have a level of cashflow, that is three to four times the value of their asset. These businesses rely on cashflows to pay their suppliers, to pay their workers and they rely on their cashflow to obtain new loans from banks.

This crisis has been a cashflow crisis, making this employment engine of the UK economy most vulnerable. For example, small firms with cashflow to asset ratio above 50% account for about 10% of employment among private business.

Private businesses account for more than 60% of employment in the UK, this suggests that 6% of employment is at risk, simply as a result of the COVID-19 crisis, observes Professor Surico.

Add to that, 10% of UK firms have no cash reserves, another 25% of firms have cash reserves for three months, and only 30% of firms in the UK can survive for more than six months, without an injection of cash.

Who to save

To guide policy intervention for startups, Professor Surico argues it’s important to understand whether the crisis these firms face is supply or demand driven. He has seen in the data that consumption has dropped very sharply and very significantly, well before the fall in income. He has further identified some recovery in income, possibly driven by the job protection furlough scheme, but he has not yet seen any recovery in consumption.

This is significant because it implies a large drop in demand and as a result a drop in cashflow and therefore job creation. For example, hospitality or retail has seen a drop in new hiring as large as 70%, whereas healthcare has seen an increase in hiring.

In the case of the startup financed against a home, this creates a problem for the government, says Professor Surico, because when you have a drop in cashflow and a drop in the house value against which your corporate debt is secured, not only are you illiquid, you might well become insolvent if the drop in demand is prolonged.

Should the government try to rescue all those firms? Textbook economics and finance will tell you to save those that are illiquid but solvent, but what if swathes of firms in a sector also become insolvent, should the government think of subsidising the losing sector by acting on the winning sector? Should a government devise a reallocation policy in the labour market to try to shift the excess of labour supply in one sector towards one where there is an excess of labour demand?

Weak companies

While the shock of lockdown has been devastating to business, banks and government have stepped in to meet the demand for cash. Thanks to measures brought in after the 2008 crisis, chiefly Basel III, banks have been required to have more capital and have been able to continue to lend to businesses. Government too, has pumped millions into the economy, having learned the lesson from the austerity policies put in place after 2008.

This is a vital but temporary solution that could saddle some weaker companies with too much debt, says Professor Rey. Overindebted firms  are not able to invest as much as they should, not able to hire as much as they should, and in the longer run banks will see more nonperforming loans on their balance sheets. These ‘zombie firms’ are alive but not functioning properly, preventing the reallocation of those resources to better performing businesses and sectors.

The social value of a company

How do we recapitalise viable firms, when whole tracts of the economy, including good firms, are in such deep trouble? How do we change too much debt into firm equity?

Saving everyone is very costly for public finances and if we consider zombification it may not be desirable either. Professor Rey also warns that the private sector is not going to be able to optimise the restructuring on its own. A laissez-faire policy would create too many bankruptcies and liquidations that could trigger a devastating domino effect.

In fact, taking these negative externalities into account, the social value of a firm substantially exceeds its private value, says Professor Rey. The private value, which a bank would look at, doesn’t consider the spillover of a business collapsing on production chains or on the labour market.

Policymakers must tip the balance against knock on effects that create massive unemployment and social problems, without stifling the need for some closures and sectoral reallocation.

The question becomes, how can policy sort between viable and non-viable firms, within the huge uncertainty portrayed by Professor Surico?

The situation is more complex for small firms whose equity is difficult to value, agrees Professor Rey. She suggests guaranteed loans be exchanged into ex-post share of profits or into quasi-equity, such as long maturity junior debt. For larger firms, government can use standard instruments like non-voting preferred stocks.

But, even once you’ve decided how to help firms, you have a more fundamental question – who should conduct this complex screening? Should it be the banks, investment funds, the government?

As lockdown ends and public support policies are withdrawn, these choices are going to sharpen the tension between saving companies and jobs, and sectoral reallocation.

Policymakers face a crucial balance between two extremes. On the one hand, laissez-faire policies that risk a domino effect of bankruptcies across the economy, and indiscriminate support that ties the economy to zombie firms that depress the recovery and deplete public finances.