Our Economics department keeps track of all the important developments in the financial markets in both advanced economies and emerging markets. We are publishing periodic briefings with analytical assessments of the current macroeconomic and financial market situation. Find out more about the EIB Group's response to the crisis

Overview

Part I. Recent economic developments

The real economy – Incoming monthly data (purchasing mangers’ indexes, EU business and consumer confidence indicators) and the EIB Economics Department’s coincidence indicators for May show some mild improvement month on month, but still point to a severe economic recession, with GDP levels below pre-COVID-19 levels.  

The new European Central Bank (ECB) forecasts expect the euro area economy to contract by 8.7% in 2020 and expand by 5.2% in 2021 and 3.3%, in 2022, confirming a U-shaped recovery. Inflation is expected to slow substantially, falling to 0.3% this year before increasing to 0.8% in 2021 and 1.3% in 2022. The ECB also expects the unemployment rate to peak at 10.1% in 2021, and average general government debt for countries in the euro area to reach 101% in 2020.

Financial markets and access to credit – European stock markets strengthened in recent weeks. The stock prices of non-financial corporations have continued to rise from the lows of late March. Share prices have  recovered about half of losses recorded since the beginning of the year. Conversely, banks’ stock prices have remained almost flat, 40% below December 2019 levels. Credit risk (measured in the spreads of credit default swaps) has continued to decline for banks, but remains higher before the COVID-19 pandemic. Turning to emerging markets, stock prices climbed to their highest level in almost three months at the beginning of June, curbing losses from since the beginning of the year to about 14%. In line with the higher risk appetite, the spreads on emerging market sovereign bonds also declined, while emerging market currencies strengthened.

Part II. Special topic: Corporate investment, debt and policy response

Corporate financing and corporate investment outlook – Our special feature below, “From liquidity shortfalls to increased indebtedness, a bleak outlook for EU corporate investment”, focuses the outlook for corporate finance and investment. Extending the analysis presented in a previous edition (15 April) of this bi-weekly series, we consider the impact of the prolongation of the crisis on EU corporate liquidity and medium-term strategies and estimate the impact of two different deconfinement scenarios, lasting three and six months, respectively. The crisis and the subsequent recovery process might lead to a cumulative reduction in net corporate revenues of €1.9 trillion and €3.4 trillion (13% to 24% of EU gross domestic product, or GDP). To compensate for this decline, firms will have to change their mid-term strategies, facing a hard trade-off between medium to long term business prospects (requiring more investment) or financial sustainability (implying lower leverage). They can either try to preserve investment, at the cost of higher leverage, potentially exposing themselves to solvency issues, or prevent substantial leverage increases, by substantially cutting investment.

In the less adverse scenario, EU corporate indebtedness rises by 4% to 6% of GDP, which would imply corporate investment shrinking by 52% and 31%, respectively. This drop in investment is more severe than during the financial crisis, when corporate investment fell by 19%. The drop in investment evokes some policy questions. In the first months of the crisis, access to liquidity was the main channel facing firms. In the medium term, however, support for the corporate sector with long term or equity instruments may help prevent excessive corporate leverage, while preserving investment and future business prospects.

Policy response – Public policy has an important role in tackling the corporate sector’s liquidity shortfall. The enhanced ECB measures as decided by the Governing Council on 4 June 2020 will further support funding conditions in the economy. When considering the specific dimension of corporate liquidity and funding, policymakers have acted swiftly, pledging support and stepping up measures such as wage subsidies, tax deferrals and loan payment delays that can alleviate the cash flow problems of both firms and households without increasing leverage. In addition, the provision of guarantee schemes (at the national and EU level) will allow the credit channel to continue to work. However, in the medium term, more structural issues of the EU financial ecosystem must be addressed. Equity instruments will be an essential part of the package, helping preserve firms’ investment, while avoiding excessive corporate leverage. As a matter of fact, equity-type of instruments represent an integral part of the EU recovery plan put forward in the Next Generation EU package (see Box). Public support to the corporate sector raises the risk of moral hazard. It is important that sufficient safety nets are put in place to prevent it. Finally, improving business environment to attract investment and support inclusive recovery should remain high on the policy agenda.

The authors of this note are: Simon Savsek, Joana Conde, Laurent Maurin, Rozalia Pal, Andrea Brasili, Matteo Ferrazzi, Aron Gereben, Emmanouil Davradakis, Koray Alper, Ricardo Santos, Sanne Zwart, Luca Gattini and Patricia Wruuck. Reviewed by Barbara Marchitto and Pedro de Lima. Responsible Director: Debora Revoltella.

1. Recent economic developments

1.1 The real economy

Various purchasing managers’ indexes (PMIs) generally point to an overall improvement of global economic conditions, but diminishing hopes for a quick recovery. The composite PMI for the euro area rose to 31.9 in May from a record low of 13.6 in April. The bulk of the improvement came from services, increasing from 12 to 30.5. The manufacturing PMI reached 39.4 in May, above April's all-time low of 33.4. Italy recorded the strongest rebound in manufacturing (with the index at 45.4 in May, up from 31.1 in April). In Spain manufacturing PMI rose from 30.8 in April to 38.8 in May. Despite these recent improvements, the composite PMI index remains at very low levels and well below 50, the dividing line between expansion and contraction, across the euro area but also in Japan, the United States, Australia and the United Kingdom (Figure 1). Notably, the composite PMI jumped across the 50 threshold on China, increasing from 47.6 in April to 54.5 in May. PMIs across emerging markets showed an improvement in manufacturing activities as well. May readings for Brazil, India and Russia all exceeded April levels, but remained below 50. While the improving indexes are in line with the gradual restart of business activities, they also illustrates the slow pace of the recovery. IHS Markit signalled that the index on “Backlogs of work”, a good indicator of capacity utilisation, continued to fall sharply in the euro area.

>@IHS / EIB
©IHS / EIB

After the steep drop in March and April, confidence indicators in the EU have showed some signs of improvement in May, albeit with considerable variations across sectors. The comprehensive Economic Sentiment Indicator, which represents a weighted average of consumers and business surveys across the European Union, increased 2.9 points to 66.7 (the long-term average is 100, while the February reading was 103). The expectation components of the indicator are typically recovering more promptly. For example, the Employment Expectation index improved faster, rising 11.3 points to 70.9. May surveys show a high degree of variation among economic sectors. Manufacturing confidence improved quite significantly (from -32.3 to -27.3), while retail trade and consumer confidence saw less improvement. Confidence indicators for services and construction are still declining. Wide differences among countries also persist.

The coincident indicators developed by the EIB’s economics department confirms a deep contraction for largest EU members (Figure 2). Electricity demand and survey indicators are slightly improving (with the exception of Italy, for which April figures were not released and May PMIs were not yet available). However, hard data on production and consumption for March and April are still extremely weak. The coincident indicator for Italy now stands at -3.65, close to the level at the peak of the financial crisis in April 2009 (the long-term average of the indicator is 0). The French indicator remains close to the 2009 levels as well, but has improved slightly. Previous declines in Spain and Germany were less steep. A clearer picture will be available when hard data is released for the on the first full month since the end of the lockdown.

>@Eurostat and ECON calculations
©Eurostat and ECON calculations

Unemployment has started to rise in the European Union. In April, the EU seasonally-adjusted unemployment rate was 6.6%, up from 6.4% in March 2020. Eurostat estimates that about 14million people in the European Union were unemployed in April, an increase of 397 000 from March. Youth unemployment rose to 15.4%, a rise of 160,000 compared with March.

All in all, a strong contraction of economic activity is projected for 2020 in the latest euro area forecasts. The new release of ECB forecasts projects the euro area economy to contract by 8.7% in 2020 and expand by 5.2% in 2021 and 3.3% in 2022, confirming a U-shaped recovery, although one in which GDP will take longer to return to pre-crisis levels. Growth projections have been significantly revised downward by 9.5 p.p. for 2020 and upward by 3.9 p.p. and 1.9 p.p for 2021 and 2022, respectively, compared to the ECB March forecast. Inflation is expected to slow substantially, reaching 0.3% this year before increasing to 0.8% and 1.3% in 2021 and 2022, reflecting to large extent energy prices. Core inflation (all prices excluding energy, food and changes in indirect taxes) is expected to reach 0.8% in 2020, 0.7% in 2021 and 0.9% in 2022. The ECB also expects the unemployment rate to peak at 10.1% in 2021, and average general government debt in the euro area to reach 101% in 2020. Due to the high uncertainty, the ECB also developed two alternative economic scenarios1. In the mild scenario, the euro area would contract by 5.9% this year, before expanding 6.8% in 2021 and 2.2% in 2022. In that scenario, GDP would return to its pre-crisis trajectory by 2022. In a more negative scenario,  GDP would contract by -12.6%, before increasing 3.3% in 2021 and 3.8% in 2022.

1.2. Financial markets and access to credit

European stock markets, corporate financing and banks

European stock markets strengthened in recent weeks. Stock prices of non-financial corporations in the European Union have continued to slowly rise from their lows of late March. Since then, non-financial corporation stocks  have recovered about half of their price, bouncing back from the lows (about a 30% loss) recorded since the beginning of the year. Conversely, since late March, banks stock prices have remained almost flat, hovering around 40% below January 2020 levels.

Economic sectors have been affected unevenly by the crisis. Since the beginning of 2020, stock markets have priced in a large decline in certain sectors, namely industrial goods, travel and leisure, and automobiles, than for any other sectors. Conversely, pharmaceutical, retail, telecom and health care services have not only rebounded from the lows hit in late March but are also close to or above December 2019 levels (Figure 3). According to many analysts, given expectations for company earnings, equities valuation is very high, supported by ample liquidity provided by central banks.

Corporate bond yields remained unchanged over the month and moved within a narrow range of 15 basis points in May (Figure 4). After rapid gains during the first half of March, the yields of non-financial corporate bonds have declined since late April, declining from 160 basis points to 130 basis points for BBB-rated corporates and from 120 basis points to 80 basis points for A-rated corporates (Figure 9). Since peaking  late March, the price of risk has decreased despite credit downgrades of many companies2. The net effect on firms’ funding costs is unclear.

>@Refinitiv and EIB calculations
©Refinitiv and EIB calculations

The latest recorded data, from March and April 2020, show that corporate bank loans have picked up strongly, rising sharply to €189 billion in the euro area. Lending to non-financial corporations was 6.6% higher year-on-year in April, up from 5.5% in March (Figure 5). According to the latest euro area bank lending survey, the main factors underlying firms’ demand in the first quarter of 2020 were financing needs for inventories and working capital, while demand for loans for fixed investment declined in net terms. Given that the financing needs were mostly related to liquidity needs, the rise in corporate loans was noticeably stronger for short-term loans than for long-term loans.

So far, corporate debt issuance has not substantially deviated from historical norms. From the beginning of the year until the end of March, net issuance of long-term debt has followed a similar pattern to last year, while net issuance of short-term debt is slightly lower, but still within the bands of normal volatility (Figure 6).

Owing to the specific public policies implemented, companies maintained confidence and have continued to access external finance. However, early signs point to a sharp rise in indebtedness. Despite waves of downgrades, the capacity to issue debt has enabled larger companies to cover their higher liquidity needs. Credit has flowed to the corporate sector and a liquidity crunch has mostly been avoided. Corporate debt, however, continues to rise. With the removal of restrictions, the slow economic recovery is likely to be accompanied by a rise in indebtedness. In the special feature (Part II), we analyse corporate financing and corporate investment outlook in greater detail.

>@ECB and EIB calculations.
©ECB and EIB calculations.

The credit risk of European financial institutions continues to decrease, but remains higher than before the COVID-19 pandemic. Credit risk as measured by financial market indicators such as the Itraxx indexes (a measure of credit risk represented by an average of credit default swap spreads for senior and subordinated debt of major European banks) continues to decrease (Figure 7). Both the senior and subordinated debt indexes have been declined substantially since mid-March, but remain at higher levels than before the COVID-19 pandemic (42 basis points for senior debt and 110 basis points for subordinated debt as of 2 June). This positive evolution shows that proactive intervention by both central banks and governments was able to stem the immediate risk of financial turmoil. However, spreads remain above their pre-COVID-19 levels, signalling that markets are still pricing higher risks, possibly anticipating a weakening in the quality of bank assets.

>@Bloomberg and ECON calculations
©Bloomberg and ECON calculations

Emerging markets 

Emerging market stocks also climbed to their highest level in almost three months. Losses for emerging market stocks now stand at about 14% year-to-date, as investors focused on improving economic data after the end of lockdown measures across much of the globe. The spreads between emerging market (dollar denominated) government debt and US Treasuries dropped to 180 basis points at the beginning of June, down from 279 basis points a month earlier. The improvement in emerging market asset performance is also reflected in foreign exchange markets. The depreciation of a basket of emerging market currencies (which is a weighted average of major emerging market currencies vs. the dollar) eased to 10.7% year-to-date from 13.7% a month earlier. Finally, the price of Brent crude oil increased to almost $40 per barrel from $26 per barrel a month earlier.

Emerging market sovereign ratings are still under pressure. Moody's downgraded India on 1 June to the lowest investment grade level and surprised economists by keeping it on a negative watch. Specifically, Moody’s cut the India's foreign currency and local currency long-term issuer ratings to Baa3 from Baa2 and retained a negative outlook. Argentina announced a new debt offering, envisaging a two year moratorium on interest payments and a delay in principal repayment for five years. Argentina’s exchange bondholder group said it was confident that its joint debt proposal with the Ad Hoc Argentine bondholder group provided a sound basis for a collaborative solution to the debt talks.

High levels of emerging market debt could amplify the adverse impact of the COVID-19 pandemic. Total outstanding debt in emerging markets has increased by $43 trillion in the last decade to $71 trillion at end-2019 (Figure 8). The increase was largely attributed to non-financial corporate debt, which has been rising steadily over the past decade. Non-financial corporate debt has increased by $18 trillion to $30 trillion before the COVID-19 outbreak. During the same period, financial sector debt (defined as the sum of outstanding bonds and cross-border loans) has increased by around $6.4 trillion to $11 trillion. By comparison, emerging market nations increased their indebtedness by $9.5 trillion to $16.7 trillion in the same period.

>@EIB
©EIB

While the bulk of the rise in emerging market corporate debt has been in local currency, foreign exchange denominated debt has nearly doubled to some $7 trillion since 2009. The emerging market corporate sector is confronted with significant debt redemptions over the next three years, which could potentially amplify the slowdown to economic activity caused by the COVID-19 pandemic. The combined debt redemptions for non-financial and financial corporations once bonds and loans in all currencies are included surpasses that of sovereigns (Figure 9).

>@EIB
©EIB

1. See Box 3 of the Eurosystem staff macroeconomic projections for the euro area, June 2020, for more details on scenarios.

2. In late May, more than 70% of firms´ debt was rated below investment grade.

2. Corporate investment, debt and policy response

As discussed in Part I, corporate sector has been substantially hit by the pandemic. Our special feature below, “From liquidity shortfalls to increased indebtedness, a bleak outlook for EU corporate investment”, focuses on corporate financing and corporate investment outlook in the first part. The second part addresses the policy response.

2.1. Corporate financing and corporate investment outlook: From liquidity shortfalls to increased indebtedness, a bleak outlook for EU corporate investment

The swift and bold reaction of policymakers (see also the following section) has helped the EU corporate sector to face the immediate risks of liquidity shortfalls emerging from the lockdown. A combination of temporary measures, ranging from relaxes social insurance contributions, grace periods on various payments, debt moratoriums and guarantee schemes and facilities, have allowed to companies to temporarily reduce payments, while maintaining their access to credit. The measures were instrumental in avoiding the possible bankruptcies caused by a halt to commercial activities.

It is now widely accepted that the economic recovery will be slow and prolonged (U-shaped), amid high uncertainty. This section investigates the impact of the next phase of the crisis on the EU corporate sector. It extends the analysis presented in a previous issue of the Covid-19 bi-weekly (published online on 15 April 2020), assessing EU firms’ balance sheets and profitability and estimating the lockdown effects and policy interventions. The analysis goes on to assess the challenges firms will face in the medium-term as revenues remain weak. Months of inactivity followed by a slow return to normal will require European firms to make a trade-off between high debt and sharp cuts in planned investment. That dynamic will renew calls for alternative sources of finance for the corporate sector – sources that tilt more toward equity instruments.

We have developed various scenarios that take into account the reduction in corporate revenue resulting from the lockdown and the long recovery. In all, corporates net revenues could decline from €1.9 trillion and €3.4 trillion (13% to 24% of EU GDP). In our estimates, EU corporate investment shrinks from 31% to 52%, and corporate indebtedness rises from  4% to 6% of GDP. Firms will have to choose between higher leverage, potentially exposing themselves to solvency issues but allowing for some investment, or  lower leverage and a more aggressive cut in investment.

Our analysis expects the impact on investment to be at least two times more than the 19% decline recorded during the financial crisis, commensurable with current macroeconomic forecasts that anticipate the impact on GDP to be much larger than during the financial crisis. The analysis begs the question of the most preferable policy intervention schemes overtime. In the first months of the crisis, extending access to liquidity and credit has been the main instrument for preventing liquidity shortfalls. In the medium term, however, growing indebtedness might drag investment down and create financial stability concerns. Going forward, support for the corporate sector will have to complement liquidity and credit instruments with more longer term equity  instruments, which avoid excessive leverage.  

The impact of the COVID crisis on the net saving capacity of non-financial corporations

We present four scenarios to illustrate the impact of the COVID-19 crisis of non-financial corporations to weather the pandemic. The scenarios combine views on the lockdown and the length of the recovery  (see Tables 1A and 2A in Appendix).

  • First, the impact of the lockdown. During the lockdown period, sales activity is assumed to decline by 70%. Input and production prices are less flexible, and, as a result, margins erode, potentially turning negative. Governments implement exceptional measures that, in the absence of data, potentially follow two different scenarios. In the policy support scenario, intermediary consumption, the value of goods and services consumed as inputs in the production process, is reduced by 60%. Temporary unemployment measures reduce salaries by 40% while moratoriums reduces rent and interest payment by 40%. In the heightened policy support scenario, intermediary consumption is reduced by 75%, temporary unemployment policies reduce salaries by 60% while moratoriums reduce rent by 60% and interest payments by 90%.
  • Second, the length of the normalisation period. We assume that the lockdown lasted for three months, from mid-February to mid-May, with economic conditions normalising progressively afterwards. In that case, a return to normal economic conditions can be expected by the end of the third quarter  or by the end of the year.

We use a comprehensive dataset of more than 1.4 million of non-financial corporations located in the European Union (EIB computations based on ORBIS). We use both balance sheet and profit and loss information. The sum of assets covered in the database amounts to around €8 trillion. For each company, we compute the cumulated change in net revenues until the end of the normalisation process in 2020 under the four scenarios, each considered separately for each corporation. The change in net revenues is computed as percentage of assets.

Across the four scenarios, the median reduction in net revenues would represent 5% to 10% of total assets (Figure 10). The least disruptive outcome is provided by stronger policy support with a three-month normalisation period. The most adverse outcome is the result of  a less robust policy support with a six-month normalisation period. Comparing the four scenarios across the length of the normalisation period, a six-month normalisation process would naturally be more disruptive than a three month normalisation period, resulting in a further decline of 1.5% of total assets. Comparing the four scenarios across the intensity of the policy support, heightened policy support could limit the reduction by 3% of assets compared to normal policy support.

For 16% to 25% of EU companies, the reduction in net revenues would be equal to to more than half their capital base (Figure 11). With a three month normalisation period, in the less robust policy scenario, two-thirds of corporations would record declines in net revenues of more than 10% of their capital and 25% of  firms would suffer declines of more than half of their equity. In the stronger policy scenario, the impact is mitigated. Two-thirds of companies would record declines in net revenues equal to more than 5% of their capital, while one-fourth would see declines worth 25% of their capital. Interestingly, only a very small portion – less than 5% of corporates – would suffer losses whipping out more than 95% of their entire capital.

>@ORBIS and EIB calculations
©ORBIS and EIB calculations

Firm size differ greatly across the corporate sector, varying the impact (Figure 12). Small and medium-sized enterprises (SMEs) – or companies with less than 250 employees – would suffer a reduction in net revenues of 6% and 11% of assets. Larger corporates, of more than 250 employees, would be significantly less impacted, with the reduction representing 2% to 4% of assets.

Given that larger corporates account for a larger share of the EU economy, weighting the estimates by size would reduce the overall decline in net revenues to 4% to 8% of total assets. Since non-consolidated total assets in the European Union amounts to €42.5 trillion, the decline represents a loss of €1.9 trillion and €3.4 trillion, or 13 to 24% of EU GDP1.

>@ORBIS and EIB calculations.
©ORBIS and EIB calculations.

Larger debt stock and bleaker investment outlook

We have applied a simplified accounting to illustrate the impact of lower revenues on companies’ balance sheets2The simplified approach assumes that all earnings are retained. Net revenues finance the accumulation of cash and liquid assets, of real investment and of debt reduction. Lower net revenues therefore result in a reduced cash balance, and/or increased indebtedness and/or lower investment.

Historical suggest that cash buffers can absorb a small part of the revenue reduction, as EU corporates entered the crisis with sizeable cash positions. During the lockdown period, these positions decreased. Post crisis, it is unlikely firms will fully restore their cash positions. We estimate that during the Lehman and sovereign debt crises, cash positions were reduced by 2% of GDP (Figure 13). According to current forecasts, during the pandemic, output will be reduced by more than during the financial crises, up to twice as much. Moreover, the given the current very low interest rate environment, return on cash and liquid assets is almost zero. Hence, we assume that following the current crisis, cash positions will absorb losses equal to 3% of GDP.

In the three-month normalisation scenario, EU corporate investment shrinks by 31% to 52%, while corporate indebtedness rises by 4% to 6% of GDP (Figure 14). According to the EIB Investment Survey, two-thirds of EU corporate investment is financed internally. After drawing on cash positions, two-thirds of the losses in net revenues (about 13% of GDP) would be absorbed by lower investment or 52% in corporate investment. Debt would also contribute to fill up the gap, rising by 4% of GDP. Alternatively, corporations could increase their access to external finance. Assuming that the whole sample of firms tap external finance, even those that would not do so in normal times, the share of external financing would rise from about 30% to 60%3. Investment would then decline by 31% compared to 2019 levels, or 4% of GDP, but indebtedness would increase by 6% of GDP.

>@Eurostat / ORBIS and ECON calculations
©Eurostat / ORBIS and ECON calculations

Conclusions    

We may have reached the peak of the COVID-19 crisis, but the return to normal economic conditions will be slow. The crisis will have a major and long-lasting impact on corporate balance sheets. Despite the various policy measures implemented to support companies, revenues will be lower. These lower revenues will likely hamper investment and increase indebtedness, forcing companies into a trade-off between leverage and investment. The  analysis estimates a greater investment impact than during the financial crisis, possibly up to two times more. To compare, corporate investment fell 19% during the financial crisis (Figure 15). GDP is also expected to be hit.

>@Eurostat and ECON calculations
©Eurostat and ECON calculations

The simulations may indicate optimal times to phase out policy intervention during the crisis. In an immediate response, policymakers have implemented various initiatives, such as payment deferrals, repayment delays and guarantees to ease access to credit and preserve firms’ liquidity. These policies are by nature limited in time. Overall, the bleak outlook for EU corporates suggests the need for new policy tools to support corporate solvency through longer term equity instruments, thereby avoiding a protracted period of weak economic growth.

2.2 Policies supporting the corporate recovery

Public policy has an important role to play in tackling a liquidity crunch. Distressed firms are likely to cut investment, reduce their business activity and lay off their employees. Lenders with underperforming loans are also likely to halt further lending. By supporting the cash flows and revenues of troubled firms, governments can limit the effect of the crisis, helping firms to continue to pay employees, suppliers and creditors. Liquidity is also important to keep firms afloat.

Overview of measures by Member States and the European Union

Central banks have played an important role in aiding liquidity and funding conditions. In this respect, the ECB has expanded its pandemic targeted asset purchase programme (PEPP) June 44.The envelope for the PEPP will be increased by €600 billion to reach a total of €1.35 trillion in support for the euro area economy.  The purchases will continue to be conducted in a flexible manner. The horizon for net purchases will be extended to at least the end of June 2021, and the maturing principal payments from securities purchased under the PEPP will be reinvested until at least the end of 2022. Net purchases under the Asset Purchase Programme will continue at a monthly pace of €20 billion as well as reinvestments of the principal payments from maturing securities. Moreover, the ECB indicated that interest rates will remain at their present or lower levels until the inflation outlook converges to a level sufficiently close to 2%.

Other large-scale measures supporting access to external finance have also been crucial. Policymakers have acted swiftly, pledging support and stepping up measures to support companies as developments unfolded. Policy responses by national governments, including fiscal stimulus and liquidity support measures, are estimated to be worth about 20% of EU GDP. However, the various national schemes differ significantly in size and design, with the risk of creating an uneven playing field across EU members. At the same time, boosting access to (emergency) loans has clearly been one of the most popular responses to the crisis. National measures supporting corporate lending are complemented by EU-level instruments, such as the Pan-European Guarantee Fund.

While accumulating debt may be necessary in the short term, companies will have a hard time sustaining high levels of indebtedness. As discussed in the previous section, a large number of European firms are likely to reach excessive levels of debt as the COVID-19 crisis unfolds. The consequence is that a large share of EU firms will enter the recovery period with pressure to reduce debt. That pressure is likely to weigh on companies’ investment plans.

Wage subsidies, tax deferrals and loan payment deferrals can alleviate the cash flow problems, but their impact is limited. All Member States have implemented some form of tax holiday as part of their policy response measures. Similarly, a large majority of nations have implemented some form of wage subsidies, such as short-term work schemes to maintain employment and support corporate liquidity (Table 1). However, these programmes are limited in scope and scale, and they do not necessarily specifically target those firms that are most in need.

>@IMF, OECD and EIB calculations.
©IMF, OECD and EIB calculations.

In many cases, grants can also play a role in aiding companies with excessive leverage. Business grants are part of the policy response in about two-thirds of Member States. As part of the overall stimulus package, the grant component is relatively strong in Germany and Austria5. In Germany for example, the government support included grants to small business owners and self-employed people severely affected by the crisis, with additional support possible from the federal level and a protective shield put in place for start-ups. In Austria, the €15 billion “Corona assistance fund” for support to sectors particularly affected (notably with huge decline in revenue during lockdown) includes a grant and guarantee component.

Publicly funded equity instruments can also complement loans and guarantees, alleviating leverage constraints. Equity instruments could absorb losses and also share eventual future profits. However, reaching out to firms, especially to SMEs, with equity instruments is difficult, as owners are often reluctant to bring on outside owners, especially if they have  voting rights. To overcome this problem, various solutions have been proposed. For instance, a creative academic proposal suggests cash could be offered to firms in exchange for a temporary increase in the tax rate of company profits after the crisis6. Another difficulty in reaching small companies is their lack of familiarity with some equity  instruments, which reflects the less-developed capital markets in many parts of the European Union. Only some Member States put dedicated equity instruments into operation as a response to the previous financial and sovereign debt crisis7.

Equity instruments are an integral part of the EU recovery plan put forward as part of the Next Generation EU package. While equity instruments have been implemented as part of the national crisis management programmes, these instruments often target large firms with strategic importance (such as airlines) or start-ups/scale ups through public venture capital schemes. The new Solvency Support Instrument (SSI) proposed as part of the European Commission’s Next Generation EU package aims to fill this gap. It will help match the recapitalisation needs of otherwise healthy companies across Europe. The instrument proposed would work in conjunction with a EU guarantee of €26 billion provided under the European Fund for Strategic Investments (EFSI). The guarantee will be used to provide financing directly or invest fund or guarantee equity funds, special purpose vehicles, investment platforms or national promotional banks, with the aim of mobilising € 300 billion for the real economy.

2.2 Discussion and pitfalls

Public support to the corporate sector inevitably raises the question of moral hazard. While this time the crisis was not triggered by excessive risk-taking by banks or firms, moral hazard exists even in the current situation. Governments have acted at an unprecedented scale, and the measures pledged and provided  will shape expectations for future crises. To limit moral hazard, measures need to be designed carefully. Support measures that restrict direct benefits for existing creditors, such as limiting dividend payments, giving taxpayers’ funds higher status in the credit hierarchy in case of restructuring, can protect against moral hazard issues. Temporary measures and built-in sunset clauses can help to avoid permanent market distortions. In addition, increasingly targeting support and devising measures with “smart conditionality,” such linking support to steps that improve firms’ longer-term resilience, such as the adoption of new business processes or digitalization, can be a way to preserve activity but also strengthen firms going forward.    

To avoid misallocation of resources in the economy, efficient insolvency procedures are key. Where insolvency regimes do not inhibit corporate restructuring, improvements in bank health tend to be associated with relatively fewer zombie firms8. Simplification and speedy court procedures matter. The time to resolve insolvencies varies significantly across EU countries, but overall the process takes longer in the European Union than, for example, in the United States or United Kingdom. (see Figure 16).

>@World Bank and EIB Calculations
©World Bank and EIB Calculations

Policy support measures need to go beyond existing businesses and preserving employment and incorporate and look forward. To that extent, micro measures, such as targeted support for some firms such as start-ups or “smart conditionality” measures and improvements of the macro and business environment need to limit the ‘status quo bias’, zombification, and misallocation of resources in European economies. Some policy support measures put forward by Member States have included stronger “forward-looking components,” supporting transformation processes at the firm level, for example through digitalization or retraining possibilities, or on a larger scale, by supporting green renovations of public housing or climate-change related investment projects. These initiatives will be important to boosting the recovery  (Table 2). At the EU level, structural transformation is at the core of the Next Generation EU plan (Box 1), which integrates climate change mitigation and digitalization into recovery support.

>@IMF, OECD and EIB calculations.
©IMF, OECD and EIB calculations.

1. According to Eurostat, EU GDP amounted to 13.9 EUR tn in 2019.

2. ∆Net revenues = ∆Cash – ∆Debt – ∆Inv. Where Inv stands for investment.

3. According to the EIBIS, around one-half of corporates access external ressources to finance their investment. When they do so, their funding mix consists of 60% of external finance and 40% internal finance (median values).

4. See also the ECB Monetary Policy Decisions, June 4 2020.

5. Based on IHS Markit information.

6. See Arnoud Boot, Elena Carletti, Hans‐Helmut Kotz, Jan Pieter Krahnen, Loriana Pelizzon, Marti Subrahmanyam: Coronavirus and financial stability 3.0: Try equity – risk sharing for companies, large and small, VoxEU, 3 April 2020 and Arnoud Boot, Elena Carletti, Hans‐Helmut Kotz, Jan Pieter Krahnen, Loriana Pelizzon, Marti Subrahmanyam: Corona and Financial Stability 4.0: Implementing a European Pandemic Equity Fund, VoxEU, 25 April 2020.

7. Examples include altum in Latvia or BPI via its investment arm. See Wruuck (2015): Promoting investment and growth: the role of development banks in Europe. EU Monitor Deutsche Bank Research.

8. Adalet McGowan, M and D Andrews (2018), "Design of insolvency regimes across countries", OECD Economics Department working paper 1504.

3. Conclusions

Economic data show some signs of improvement, although many indexes remain negative. The sentiment confirms the idea that the EU economy will face an unprecedented contraction in 2020. The policy focus is  shifting to measures that will put the recovery on a solid footing and address the long-standing challenges EU countries will face as a result of the pandemic.

EU public support will therefore remain crucial going forward. It will also need to take into account elevated debt levels, in the public or private sector. As public support to the private sector always raises the question of moral hazard, transparency and smart incentives will be crucial. Also, going beyond the immediate liquidity needs of the corporate sector, longer term, equity instruments should be considered to avoid excessive corporate leverage and preserve financial stability.