We do not yet know if the pick-up in coronavirus cases around Europe will send economies into a new downturn, or be manageable without great disruption. Governments may feel forced into lockdowns again. Even if they don’t, renewed fear may interrupt a return to normality. Alternatively, hospitalisation numbers may remain sufficiently low that most activity can resume.
What we do know, but are not treating urgently enough, is the serious damage that has already been done to Europe’s corporate economy. Many companies’ balance sheets have been hurt so badly as to put in doubt their ability to return to normal, let alone contribute to renewed growth. Even an unrealistically best-case scenario — where the virus recedes and activity bounces back — leaves serious problems.
Welcome to the zombie economy. The steepest downturn in generations forced many European companies to run down cash reserves and increase debt to the point where their solvency is threadbare. In May, the European Commission calculated that, in a relatively optimistic scenario, corporate Europe would lose €720bn by the end of the year. One-quarter of all European companies with more than 20 employees would exhaust their working capital and run out of cash by then, even when benefiting from wage subsidies. The economy has in fact performed somewhat worse than those calculations assumed.
While the situation would surely have been worse had governments not stepped in to subsidise costs and ensure cheap and accessible credit, a loss temporarily paid for by a loan is still a loss and the erosion of corporate capital a danger to the economy.
A large number of undercapitalised companies will hold back Europe’s economic performance in two ways.
First, they do not invest. Simulations by the European Investment Bank show that European corporate investment could fall by more than half to meet cash needs. In coming years, businesses whose revenues barely cover their debt service — even with current record-low borrowing costs — cannot be counted on to make the big investment commitments that Europe needs.
Second, many businesses whose revenues largely go to debt service can, at best, hope to delay their inevitable insolvency. The wider economy’s interest in what happens to such companies is mixed. Keep them alive for too long and you stop workers and capital from moving to more productive activities — the process optimistically known as “creative destruction”. But a wave of insolvencies could also bring destruction without the creation.
As employer-employee relationships are severed, accumulated company-specific knowledge is lost; machines and skills atrophy as they wait to find new uses. In addition, the financially weakest companies are not always the same as the least productive ones. In France, studies have found that a surprisingly large share of companies with pandemic-related solvency problems are at the top of their sectors in terms of productivity. As economist Marcel Fratzscher recently quipped: the biggest zombie company there ever was is Amazon.
All of this points to an urgent need to recapitalise much of corporate Europe to reduce debt overhangs without killing otherwise viable activities. Recapitalisation is particularly urgent for the small to midsized companies that in Europe have less access to equity markets than their counterparts in the US.
The question is how governments can make recapitalisation happen. At one extreme, repairing corporate balance sheets through straightforward grants would be extremely expensive and potentially poorly targeted: some of those teetering on insolvency were already moribund before Covid-19. At the other, bankruptcy can lead to liquidation rather than restructuring of otherwise productive businesses.
The solution is to inject new equity, either from taxpayer support in return for partial ownership stakes, or from creditors through expedited insolvency procedures that restructure companies without liquidating them. Subsidised terms can limit dilutions at small or family-owned companies if that is desired. In the spring, such plans were debated but governments have since lost interest. In July, European leaders rejected a proposal for just such a “solvency support” fund in order to reach an otherwise path-breaking agreement on joint borrowing for a recovery package.
That has left national governments to do the job. Brussels has relaxed its state aid rules to allow this but, even so, the lack of a pan-European recapitalisation approach is a missed opportunity. Over-reliance on bank credit saps smaller European businesses of dynamism at the best of times. The equity financing that should support risk-taking entrepreneurs is too shallow. Crisis recapitalisation could have kickstarted the EU’s ambition for a capital markets union, by having public schemes or restructured private creditors bring many European companies to equity markets for the first time.
It is said that a crisis is always also an opportunity. If the EU botches the repair of Europe’s corporate balance sheets, it risks mishandling both.