Tatiana Didier, Federico Huneeus, Mauricio Larrain, Sergio Schmukler24 April 2020
The COVID-19 outbreak has imposed a heavy toll on economic activity worldwide. To diminish the number of concurrently infected people and to accommodate for proper hospital care for the sick, policymakers were forced to impose social distancing measures to ‘flatten the curve’ of infections. Such measures have led to a synchronised collapse in economic activity across industries around the world. It has also disturbed a wide range of economic relationships, like those between firms and their multiple stakeholders.
With business revenue plummeting, corporate cash flows have collapsed at an unprecedented scale. Firms have struggled to survive as their working capital is rapidly depleted. In some of the industries that have been hit hardest by the pandemic crisis, firms might last for only a few weeks as revenues cease entirely (Figure 1). The resilience of the corporate sector is thus tightly linked to the highly uncertain magnitude and duration of the pandemic. A firm’s ability to continue operating during and after the shock also depends on whether it can raise additional financing, as well as on its ability to adjust its operating expenses.
Figure 1 Days of cash on hand across industries
Note: Days of cash on hand refers to days of operating expenses covered by cash held, across US-listed firms by industry. The figure shows 2000-2016 averages.
Policymakers around the world have rapidly deployed a wide arsenal of tools to cope with the inevitable economic recession, pledging aid to firms in Europe and the US equivalent to their entire profits for the past two years (The Economist 2020). Many of these policies focus on helping firms manage the crisis (Ilzetzki 2020). Germany’s ‘bazooka program’ included €550 billion in new loans to firms through its state investment bank (Garicano 2020). In the US, a relief package of over $2 trillion has provided economic assistance to households and firms (Baldwin et al. 2020). The Federal Reserve has also extended liquidity to firms through the purchases of financial securities in capital markets (De Vito et al. 2020).
Economists have come up with several other proposals. Governments could be the backstop for absorbing losses (Beck 2020) or act as a ‘payer of last resort’ (Saez and Zucman 2020). Others have suggested ‘shield packages’ aimed at supporting firms in financial distress (Benassy-Quere et al. 2020, Bofinger et al. 2020). Additional proposals include a negative lump sum tax for small and medium enterprises (SMEs) (Drechsel and Kalemli-Özcan 2020), a liquidity life-line to cash-strapped firms (Brunnermeier et al. 2020), evergreening loans (Brunnermeier and Krishnamurthy 2020), and preserving bank capital (Acharya and Steffen 2020).
Whereas many of these proposals aim at saving firms, they are not explicit about why it is important to do so, how to do it more effectively, and how governments can help in working with the financial sector. We contribute to this debate by making three related points.
First, firms’ relationships with different stakeholders are an essential part of their intangible capital. Breaking them would have longer-term economic consequences and hysteresis effects.
Second, to survive firms would benefit from ‘hibernating’. To do so, they need financing.
Third, governments need to adopt new policies to help finance firms during the hibernation period.
The importance of firm relationships
Firms depend on key and unique relationships with different stakeholders such as workers, suppliers, customers, governments, and creditors. These relationships are costly and time-consuming to build, maintain, and adjust. They usually entail relationship-specific investments that involve the creation of knowledge and reputation. For example, firms must learn about workers’ skills and capabilities, develop methods to adapt specific intermediate inputs to production lines, and seek investors that might be better suited for their financing needs. These relationships (or ‘matches’), and the knowledge embedded in them, can be thought of an important intangible asset, or organisational capital, for firms.
Pushing firms into bankruptcy would mean that the different relationships would need to be redeveloped during the recovery following the crisis. The ‘churning’ process of destroying, and then recreating, relationships and contracts is far from efficient, as it is generally slow and costly. A transitory shock that destroys a significant mass of relationships could lead to long-term scarring economic effects, and a slow recovery.
Financing during the hibernation
Given the transitory nature of the shock, one option might be hibernation. This would involve slowing the economy until the pandemic is brought under control. Hibernation means using the minimum bare cash necessary to withstand the pandemic. It is intended to freeze firms’ relationships with their stakeholders. Even firms that have ceased operations during the lockdown would need some minimal funds in order to stay alive and remain ready to reopen when the lockdown eases (akin to the energy that animals need during their hibernation). The idea of hibernation might differ from other ideas related to freezing the economy in the sense that it makes it explicit that firms incur a variety of costs during the lockdown.
Hibernation would not be a simple solution, as the relationships between firms and their different stakeholders (and the contracts that support them) might need to be renegotiated to somehow share the burden of the inactivity. Borrowing to maintain all preexisting contracts (assuming business as usual) could generate a high, and perhaps unbearable, debt burden on firms by the time the recovery starts. An ensuing debt overhang problem could linger for several years.
Creditors could provide a crucial margin of adjustment for firms, especially if they could offer extra financing that would allow firms to cover their reduced operational costs and avoid breaking up their other relationships. This means not only refinancing existing credit lines, but also extending new financing, given that funding needs will likely increase with the ensuing economic recession. This can be particularly challenging as many firms have entered this shock with high levels of pre-existing debt, accumulated since the Global Crisis.
Financial sector and policy responses
Despite the desirability for more credit to sustain firms during the hibernation period, existing crisis resolution mechanisms (revised after previous financial crises) are not designed to deal with an exogenous, systemic shock such as the COVID-19 pandemic. They are focused on mitigating the spillovers of shocks that originate from the financial sector by, for example, isolating banks or firms in trouble and protecting the rest.
During the pandemic, the financial sector faces other types of problems. Creditors have become reluctant to lend to firms, unwilling to absorb the higher credit risk of firms. Creditors have imperfect information about firms’ flexibility in their contracts with other stakeholders and have encountered significant challenges in evaluating their repayment capacity in light of the heightened uncertainty surrounding the crisis. Thus, creditors might cut financing across the board. Firms that are unable to obtain financing during the hibernation phase would have a lower chance of survival.
Policymakers could play a key role in stabilising the economy by working with the financial sector to keep firms afloat, improving the likelihood that viable firms are not pushed into bankruptcy (Didier et al. 2020). One set of policies relates to adapting the existing regulatory and institutional frameworks. Signaling firms in trouble would not be very informative during the pandemic, given that most firms have suffered a sizeable exogenous (and unexpected) negative shock. To the extent that financial sector stability can be preserved, allowing forbearance and avoiding undue increases in borrowing costs might be needed. Otherwise, applying the standard procedures when firms cannot repay their liabilities would hurt these firms even more.
A second set of policies is linked to the provision of credit to firms through monetary and regulatory policies. For example, some central banks have extended liquidity lines to banks, at low costs. However, such policies would work only to the extent that banks are willing to pass through the higher liquidity from the central bank on to firms. In light of the higher credit risk, many banks might be unwilling to do so.
A third set of policies focuses on ‘fostering’ firm financing through the transfer of credit risks to the government. Because uncertainty is high, and lenders have retrenched, governments have stepped in and absorbed the increased risk in credit provision to ensure that credit flows to firms. Among other things, governments have capitalised state-owned banks, scaled up public credit guarantee programs, and supported large-scale purchases of portfolios of loans.
Policy interventions would benefit from scale to minimise the costs of these interventions by allowing for risk diversification, both across industries and across firms within industries. Providing incentives for both creditors and debtors is also important. For example, public credit guarantee schemes should be partial, so that banks retain some ‘skin in the game’, and thus have incentives to monitor and screen borrowers. In applying forbearance, it is important that regulators and creditors do not provide the wrong incentives for borrowers to engage in moral hazard ex post.
Governments have limited resources, so they need to evaluate the trade-offs associated with different policies, prioritise, and coordinate. For example, they need to make decisions on how much to allocate to large firms versus SMEs. They also need to discern how much should be allocated to firms that have relationships that are more difficult to reconstruct, as well deciding how much should be allocated to firms that would be more disruptive for wider value chains (if they were to go bankrupt). They might even be pushed to decide whether some essential industries (or industries hit hardest by the shock) are worth assisting over others. Governments also need to think about how to allocate resources over time.
In designing policies, it is useful to acknowledge the transfers across different agents that can occur. The lockdown policies will tend to induce transfers from the young to the old (the demographic most vulnerable and are least likely to be working in the first place). However, policies to keep firms alive do not produce the same type of intergenerational transfers. They will be paid for mostly by the young. The same generation will also benefit the most from keeping the relationships between firms and their different stakeholders alive.
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Brunnermeier, M and A Krishnamurthy (2020), “Stick, Carrot, and Evergreen Loans: A Policy Proposal to Save Small and Medium-sized Firms”, Pro-Market blog, University of Chicago, Booth School Business and Economics for Inclusive Prosperity (Econfip).
Brunnermeier, M, J-P Landau, M Pagano and R Reis (2020), “Throwing a COVID-19 Liquidity Life-Line”, Economics for Inclusive Prosperity (Econfip).