Financial policy and UK business

Spotlight on the UK economy: A Wheeler Institute webinar series

The measures taken after the 2008 financial crisis have protected the economy but how much can the UK take? Hélène Rey, Lord Raj Bagri Professor of Economics and Paolo Surico, Professor of Economics join Elias Papaioannou, Co-Academic Director of the Wheeler Institute, to consider some of the biggest economic challenges facing the UK as a result of COVID-19.

Paolo Surico surveys the condition and characteristics of the small businesses that employ most of the UK’s workforce – their vulnerabilities and the areas where government policy can make the biggest difference. Hélène Rey sets out her concerns around the potential long-term and scarring effects of mass unemployment and bankruptcies. She also suggests ways to counter some of the worst-case scenarios.

Key Takeaways:

  • Small and medium enterprises, who contribute to most job creation in the UK, are reliant on borrowing linked to directors’ assets (i.e. the value of their homes); the smaller the firm the larger share of residential real estate as a fraction of total assets;
  • Small firms with a cash flow to asset ratio above 50% account for 10% of employment among private businesses; as private firms account for more than 60% of employment, this means that around 6% of all jobs are at risk as a result of COVID-19;
  • These small, young firms are more highly levered and have immediate cash flow requirements to run their business. They need to pay suppliers and workers and accordingly, are hit hardest by cash flow crisis – 10% of UK firms have no cash reserve for less than a month and 25% only have cash reserves for three months, while only 30% of firms in the UK can survive for more than six months without an immediate cash injection;
  • COVID-19 has resulted in a significant drop in consumption, leading to a lack of sales and accordingly a cash flow problem, as well as wider issues relating to falling house prices and a lack of liquidity on the housing market;
  • The consequences of the pandemic may lead to firms that would ordinarily be solvent having liquidity issues and no longer maintaining creditworthiness; there is a question whether the Government should step in to support all of these troubled firms? Similarly, to what extent should the government pose conditionality for its support? And is it beholden on those companies that have prospered during the crisis to subsidise those that have been negatively impacted?
  • There are some sectors which are more affected and for some of them, the response to the large drop in demand for their product is to reduce their hiring. Accordingly, sectors like hospitality or retail have seen a drop in new hiring as large as 70%;
  • We have observed significant heterogeneity in product demand and relative prices across sectors; the fluctuation in online prices poses a serious challenge for policy relating to the measurement of inflation and measures to target inflation in the face of so much volatility and so much dispersion in relative prices;
  • The magnitude of the COVID shock is impressive and it has attacked the real economy in a way that the financial crisis did not. As Government support policies are gradually withdrawn, there is a significant risk of bankruptcies and spiralling unemployment;
  • UK companies have increased the amount of debt that they hold; there will be a tension between saving companies that employ significant portions of the workforce and allowing sectoral reallocation for the sectors that will strengthen as a result of COVID-19;
  • There has been a serious tightening of financial conditions in the UK, as can be seen by the increasing bond spreads across different categories, in some instances, these have exceeded levels seen during the Global Financial Crisis and the Euro Area crisis of 2012;
  • The Bank of England and the COVID Corporate Credit Facility have helped companies to go to the market and raise money as bridge financing to survive this very difficult period with the loss of sales; UK banks net lending to corporates has increased to £33 billion in March which is around 30 times the average monthly lending seen in 2019;
  • There is a concern that over-indebtedness of firms, which is going to lead them not to be able to invest as much as they should not to be able to hire as much as they should, and increase the risks of nonperforming loans on bank balance sheets going up;
  • As lockdown measures ease, there is a complex trade-off between protection of workers and firms as well as a reallocation of capital across sectors where it will be most productive. A laissez-faire approach will result in too many bankruptcies and liquidations, because the social value of a firm substantially exceeds its private value, while the network effects of this would result in a depressed economy which governments will be keen to avoid,
  • Propping up ‘zombie’ firms who should disappear is also a long-term risk and very important for the future potential growth of the UK economy since indebted firms will not invest and do not hire much; ‘Zombie’ firms have large amounts of debt and cannot afford to invest because of interest payments; leverage means they do not provide future potential growth for the economy; they cause a congestion effect by maintaining an artificially high cost for labour and capital;
  • There will need to be policy considerations relating to finding a cost-efficient method to recapitalise the private sector without government support; a debt-for-equity-swap could be an effective way of avoiding too many ‘zombie’ firms from emerging;
  • Furthermore, how do we sort between viable and non-viable firms with this huge uncertainty? Large traded firms and small firms need very different schemes; who should do the screening? The banks, investment funds, the government? What type of financial instruments should be used? For large firms, standard instruments like non-voting preferred stocks can be used if they need to be recapitalised, for SME’s it is a log more difficult.

Conclusion:

  • Challenges such as Brexit are considerably smaller than COVID-19; no more than 55% of firms considered Brexit as their top uncertainty; conversely, around 80% of firms consider COVID-19 as a cause of uncertainty; so if Brexit uncertainty was bad with an 11% drop in investment and a 3 to 5% drop in productivity, COVID-19 uncertainty is in order of magnitude larger.
  • Government support systems do not solve the problems caused by COVID-19, they only address the consequences. When the furlough scheme ends in October, there will need to have been a reallocation of labour from where supply is high to where there is demand, otherwise, all the employment scheme will have done is push the same situation than if the government did not intervene at all, just later. The government needs to be more proactive on the demand side and treat the causes of the crisis, not just the consequences. 
  • The banking system has really been able to absorb a massive shock to the economy; there has been resilience in banking systems, not only in the UK but also elsewhere. If there had been a similar pandemic shock which had struck the banking system before the financial crisis of 2008, the overall impact of such an incredible shock would have wiped out a lot of the aggregate capital in the system. Changes in banking regulation put in place after the 2008 crisis, in particular the Basel III regulations, have increased resilience through capital adequacy buffers.
  • There is an important tension between creative destruction and sectoral reallocation in the form of inefficiencies and massive unemployment and social problems. The economy will suffer scarring if there is a limited reallocation of capital across sectors because unemployment goes up resulting in human capital consequences for the long run. Also if too many firms go bankrupt there will be negative externalities and an amplification effect on the economy.
  • The economic bottleneck is the top five 25% of people at the of income distribution contributing to 46% of the drop in aggregate demand. The government needs to incentivise these households and stimulate demand by discouraging saving at the top of the income distribution and at the same time allowing the reallocation of capital to firms there where there is more demand following the COVID19 shock.

If you’re interested in following the Wheeler Institute COVID-19 series, check out our COVID-19 series.

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