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BIS Bulletin No. 30: The Outlook for Business Bankruptcies

Core Content

This BIS Bulletin examines the outlook for business bankruptcies in advanced economies (AEs) in the context of the global economic impact of the Covid-19 pandemic. It highlights the divergence between financial market indicators of default risk and the actual trajectory of economic activity, emphasizing the role of government support and the potential long-term consequences of prolonged credit easing.

Main Points

• Economic Growth and Default Risk: In advanced economies, business bankruptcies are predicted to rise significantly by the end of 2021. This is primarily driven by the expected rebound in real GDP growth, rather than financial market-based default indicators.
• Historical Trends: Business bankruptcies typically increase during economic downturns. However, during the early stages of the pandemic, the number of bankruptcies remained relatively low despite the sharp contraction in GDP.
• Market Indicators: Equity market-based default indicators, such as EDFs (Expected Default Frequencies), have not reflected the same level of risk as the economic data. This suggests a disconnect between market expectations and actual economic conditions.
• Government Support: The unprecedented level of policy support, including monetary easing, direct lending, and public guarantees, has helped to suppress the rise in bankruptcies and insolvencies.
• Sectoral Differences: EDFs vary across sectors, indicating that certain parts of the economy face higher default risk than others.

Key Findings

• Projected Increase in Bankruptcies: Business bankruptcies across AEs are projected to increase by 19–55% in 2020, with an average increase of 33%. By 2021, the number is expected to fall slightly as GDP growth rebounds, but still show an overall rise of about 20%.
• Role of EDFs: EDFs, derived from equity prices, have not contributed significantly to the projected increase in bankruptcies, unlike in past downturns. This is attributed to the buoyant equity markets and the perception of short-lived economic shocks.
• Policy Implications: Policymakers face a difficult trade-off. Prolonged support may lead to the "zombie firm" phenomenon, where unproductive firms remain in operation due to continued access to credit. Conversely, premature withdrawal of support could cause a liquidity crisis, triggering a surge in defaults and destabilizing the financial system.

Financial Market Signals

• Corporate Bond Spreads: After a spike in March 2020, corporate bond spreads have returned to longer-run levels, suggesting that investors do not expect a large number of defaults.
• Equity Market EDFs: While EDFs rose sharply in the early stages of the pandemic, they have since receded to historical norms in AEs and are well below long-run levels in emerging market economies (EMEs).
• Bank Provisioning: Despite the economic downturn, banks have not significantly increased loss provisions, indicating a mismatch between actual economic conditions and market expectations.

Policy Recommendations

• Gradual Withdrawal of Support: Central banks and governments should consider spacing out the maturity of support programs to avoid a "cliff effect" where firms face a sudden loss of funding.
• Avoiding Zombie Firms: Prolonged credit support may lead to the persistence of unproductive firms, which can hinder productivity growth and delay economic recovery.
• Monitoring Default Risk: Policymakers should closely monitor default risk indicators and ensure that support is targeted at viable firms while allowing for necessary restructuring.

Conclusion

The pandemic has created a unique situation where financial market indicators of default risk are not aligning with economic projections. This divergence is largely due to the substantial government support provided to the business sector. As the economy begins to recover, the challenge will be to manage the transition from support to market-driven outcomes without causing further instability. Policymakers must balance the need to sustain economic activity with the imperative to ensure that credit is allocated efficiently and that the financial system remains resilient.