In the decade after the global financial crisis, in a time of low-interest rates, businesses in many countries have leveraged up. Time-tested indicators of exuberance in corporate lending markets such as the share of high yield bond issuance, covenant-lite lending, and issuance of collateralized loan obligations (CLOs) were all flashing red at some point in recent years. While quantities of credit were rising fast, the price of corporate credit risk in financial markets fell substantially. Lower credit spreads despite higher volumes and lighter covenants signaled to many that a corporate credit boom had taken hold which could end badly and make a future downturn much more severe (Yellen 2019).
This was the picture before the Covid pandemic. The economic fall-out of the pandemic has exacerbated the situation in two ways. First, corporate earnings have temporarily collapsed in most industries, lowering debt service capacity. Moreover, accelerated structural change in the aftermath of the pandemic could mean that some sectors or business models are permanently impaired. Second, to bridge the revenue shortfall government facilities have been set up during the pandemic that have offered liquidity at favorable terms. They increased corporate liabilities even further. In the year 2020 alone, corporate debt to GDP levels surged by about 15pp in emerging markets and by about 10pp in advanced economies.
In our new INET Working Paper, we try to peer into the future by looking back at the past. We study past corporate credit booms and their after-effects. We ask: how severe will the aftermath of the corporate debt surge be? Do we have to dial down expectations for a swift recovery as corporate debt overhang becomes a millstone around the neck of the economy?
Two historical analogies are often invoked to highlight the risks that debt overhang could pose for the recovery. The first reference point is the experience after the global financial crisis that highlighted the role of household debt and balance sheet repair for aggregate spending. The second example is the Japanese experience in the 1990s. When the Japanese financial bubble burst, corporates were left with significant debt on their balance sheets. The debt overhang, slow restructuring of bad debts, and ongoing lending to “zombie” companies are seen as important reasons behind the prolonged recession and depressed productivity growth in Japan’s lost decades.
However, when studying the entire history of corporate credit booms in advanced economies since 1870, we find that the economic fall-out from corporate credit booms tends to be small. Unlike household credit booms, the aftermath of corporate debt cycles is not systematically associated with subpar macroeconomic performance. In the history of modern business cycles, more corporate credit-intensive expansion phases are not followed by deeper recessions and slower recoveries.
Yet there are three important caveats to this Panglossian view of corporate debt booms and their aftermath. First, not all corporate credit booms are alike. The composition of the corporate debt boom matters, as recent research has shown. Non-tradable debt is associated with macroeconomic boom and bust dynamics akin to household debt booms. Second, debt reorganization and bankruptcy codes must function reasonably smoothly and encourage swift and efficient reorganization of corporate balance sheets. If liquidation or reorganization is slow and costly, the macro-effects of corporate debt overhang become measurable and sizeable.
The third caveat relates to the origination side of corporate debt. In particular, in bank-based financial systems the risk exists that weakly capitalized or weakly supervised banks have incentives to avoid losses and evergreen bad loans in the hope of a future recovery of asset values or an improvement in the financial position of the borrower. “Extend and pretend” policies leading to “zombie lending” were arguably a major impediment to Japan’s recovery from the crisis in the 1990s.
Yet in the current situation, all three caveats only apply to a limited extent. The sectoral composition of credit in the past decade was not particularly heavy in the non-tradable sector. Progress has been made to align and accelerate corporate debt reorganization, and banking supervision and its enforcement are generally much more stringent today than in 1990s Japan.
Indebtedness and debt overhang problems in the corporate sector are often conjured as key risks for a quick rebound from the pandemic. However, recent insights from macro-financial research do not raise alarm bells. The literature makes a clear distinction between the aftermath of household credit booms – which tend to be costly – and corporate credit booms that are not systematically associated with subpar economic outcomes.
The main policy implications stemming from the history of corporate debt cycles are reasonably clear. Default rates will likely rise and not all business models have a future. In such an environment, there is nothing to fear but a policy of kicking the can down the road. Swift reorganization or liquidation of insolvent businesses is the single best policy to deal with corporate debt booms.