23 March 2022

ECB: Assessing corporate vulnerabilities in the euro area

The rapid pace of the decline in revenue in conjunction with the difficultly of adjusting costs sufficiently quickly led to a sudden increase in liquidity needs.

The coronavirus (COVID-19) crisis was a major shock for the non-financial corporate (NFC) sector. The pandemic and the associated containment measures translated into a large drop in sales for firms. The rapid pace of the decline in revenue in conjunction with the difficultly of adjusting costs sufficiently quickly led to a sudden increase in liquidity needs. These liquidity needs, if left unaddressed, could have easily morphed into broader solvency issues, leading to a sharp increase in corporate defaults and bankruptcies.

The COVID-19 pandemic hit the services sector and small firms particularly hard. There is a high concentration of small businesses in contact-intensive sectors. This creates additional challenges when assessing the vulnerability of the euro area economy, as comprehensive information on the health of small companies’ balance sheets typically becomes available only with significant time lags. The information contained in the Survey on the Access to Finance of Enterprises in the euro area (SAFE) was particularly useful to fill, at least partially, the information gap.^[1]

The timely and forceful policy response at national and EU level mitigated the short-term impact of the pandemic. Fiscal, monetary and supervisory measures have substantially supported corporates by preventing large corporate losses and a rise in non-performing loans for banks. Government support to firms helped to reduce their costs (for instance via job retention schemes) and provided liquidity support, while monetary policy helped to provide favourable financing conditions and supervisory policies freed up capital that banks could use for lending. The effect of these policy measures is also reflected in exceptionally low numbers of corporate insolvency cases over the past two years.

Two years after the onset of the pandemic, the short-term vulnerabilities of the corporate sector seem to have abated somewhat amid the ongoing recovery, but risks remain, especially for smaller firms and for sectors most affected by the pandemic. Corporate revenues recovered after some of the strictest containment measures were eased, thus also improving debt servicing capacity. At the same time, weaker corporate balance sheets and heterogenous indebtedness across firms pose risks to the recovery. Higher gross corporate debt, in particular for those firms that also face an increase in net debt, may hamper the capacity of firms to support the recovery via an increase in capital spending, especially once policy support is phased out. The higher debt ratios render firms vulnerable to potential shifts in risk sentiment, a rise in real interest rates or a fall in profits. Weaker corporate balance sheets also pose a risk for banks, potentially activating adverse feedback loops and financial stability concerns through increases in non-performing loans and corporate bankruptcies.

Aside from the COVID-19 pandemic, the corporate sector also faces broader structural challenges. The pandemic has accelerated several structural transformations already under way in the euro area economy. A non-exhaustive list of structural challenges includes new forms of work (including remote working), the use of e-commerce and digital technologies, a reconfiguration of global value chains and the transition to a carbon-neutral economy. Such changes require a comprehensive modernisation of firms’ capital stock, which may be harder for small and medium-sized enterprises (SMEs) to implement, partly owing to their pre-existing weaknesses compared with larger firms.

This article is structured as follows. Section 2 reviews recent developments, focusing on vulnerabilities stemming from corporate indebtedness. Section 3 looks at implications for corporate insolvencies, complemented by Box 1, which views this through the lens of bank asset quality. Section 4 looks at the possible investment implications of increased levels of corporate indebtedness. Box 2 discusses some structural features of euro area SMEs in the context of the COVID-19 pandemic. Section 5 concludes...

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