UK corporate debt after Covid-19: what might the impact be?

Chris Smith

How has corporate debt grown during the pandemic?

The Bank of England (‘the Bank’) said that outstanding corporate debt in the UK rose by £79bn between the end of 2019 and the first quarter of 2021. The Bank described this as a “moderate” increase. It represented a rise of around 6% in total corporate debt compared to pre-pandemic levels.

The Bank reported that the burden of increased debt varied between sectors and by size of company. For example, it stated that for large, listed companies debt did not increase significantly, although such firms did raise substantial amounts of equity. However, debt in small and medium-sized enterprises (SMEs) rose by a quarter. The Bank suggested that SMEs were more likely to have been impacted by the pandemic, as they were more likely to be in affected industries such as hospitality, arts and recreation. SMEs in these specific sectors increased their debt levels by a third, on average.

Alongside increases in debt, companies’ cash holdings have also risen. Speaking for the Government in May 2021, Lord Callanan said that government support had “ensured that the corporate sector remained resilient, with the increase in indebtedness matched by an increase in net deposits”. The Bank reported that, overall, corporate cash holdings had risen by £152bn, or 29%, since the end of 2019. It stated around half of this was from raising equity and taking on more debt. The Bank said the increase in cash reserves suggested some of the borrowing was “precautionary and may not have translated into increased vulnerability”. However, it also noted that some of this cash may have been set aside to pay arrears, such as rent and VAT, as they fall due over the coming months. This would suggest that some of the effects of the pandemic are still to be felt.

Government loans and cashflow support

In a previous article, the House of Lords Library explored how, during the pandemic, the Government has facilitated cashflow support to UK businesses amounting to over £200bn. The vast majority of this—at least £180bn, on the latest figures—has been in schemes that underwrite or support loans from high street banks to firms.

The overall increase in outstanding corporate debt of £79bn, reported by the Bank, is substantially less than the amounts of lending provided under government schemes. This suggests that other forms of debt have reduced. One explanation could be that firms have used loans under government schemes, which have more favourable terms than commercial loans, to repay other borrowing.

How vulnerable are companies to higher levels of debt?

Bank of England data and commentary

In October 2021, the Bank stated that the government loan schemes, along with other forms of business support and changes to insolvency legislation, have limited the impact of disruption to cash flows and insolvencies during the pandemic. However, the Bank also considered whether higher levels of debt post-pandemic would mean that companies are more vulnerable to future cashflow and solvency difficulties. It concluded that vulnerabilities have increased “moderately”.

The Bank measures the vulnerability of businesses to higher levels of debt using the interest coverage ratio (ICR). This is a company’s earnings divided by the interest costs on its debt. The Bank said that firms with ICRs below 2.5 are more likely to experience repayment difficulties and financial distress.

Overall, the Bank found that the impact of borrowing during the pandemic on ICRs has been limited because of the favourable terms of the government-backed schemes. These terms include lower interest rates, longer repayment periods and more repayment flexibility than companies would typically be able to obtain. However, the Bank expressed particular concern about SMEs, reflecting their greater increases in debt. It quoted statistics including:

The number of SMEs with any debt has more than doubled. Around 757,000 companies (out of the approximately 2m that have UK bank accounts) now have some debt, compared to 305,000 before Covid. The Bank said some of these “may not have previously met banks’ lending criteria”, ie may be less creditworthy and therefore less able to repay the loans.
33% of SMEs have debt levels more than 10 times their cash balance, or their cash balance is negative (ie they are using an overdraft). This has increased from 14% before Covid.
18% of SMEs have monthly debt repayments that are more than 15% of their income. This has increased from 3% before Covid.
10% of SMEs have both high debt levels and high debt repayments, using the definitions in the previous two bullet points.

The Bank described how the future of ICRs will depend on both earnings and interest payments. Interest payments, in turn, will be affected by possible future increases in interest rates. The Bank reported that rates would need to increase by up to two percentage points for the proportion of companies that have ICRs below 2.5 to reach the levels seen in the financial crisis of 2007 to 2009. It said this level of increase would take time. Therefore, the Bank did not see immediate vulnerabilities from an increase in interest rates for most companies.

Considering earnings, the Bank said the economy would need to see “very severe” earnings shocks for the proportion of companies that have ICRs below 2.5 to reach financial crisis levels. Noting analysts’ forecasts that company earnings would return to pre-Covid levels by mid-2022, the Bank concluded that “widespread debt-servicing issues were unlikely”. Again, though, it said the picture varied between companies. It described a “larger vulnerable tail” of businesses that are now less able to weather a future shock. These include companies that already had high borrowing prior to the pandemic and, with additional debt, might now be “highly leveraged”. The Bank’s analysis (published on 8 October 2021, prior to the impact of the Omicron variant) said the outlook for these companies would be heavily dependent on how economic conditions develop over the coming months.

The Bank did observe some “early evidence of stress” from the withdrawal of government support schemes and the end of temporary insolvency protections. For example, it said an increasing proportion of SMEs reported concerns about their ability to make debt repayments (7% in the second quarter of 2021, compared to 4% before the pandemic). However, the Bank reported that the major UK lending banks had “not yet reported a material deterioration in the quality of their SME loan book”.

The House of Lords Library’s earlier article on coronavirus business support loans reported official public finance forecasts, including estimates of the amount of loans under the schemes that will not be repaid. These amount to over £21bn out of the total lending and support of over £200bn.

Make UK survey

A survey for Make UK, an organisation representing UK manufacturers, reported that 45% of manufacturers responding to the survey had more debt in October 2021 than before the pandemic. Only 17% had less debt, with the remaining 39% unchanged. Moreover, 60% of respondents said they were planning to take on more debt. The most common reason given for this was to finance the normal running of the business. However, for some companies it was to fund expansion and growth.

Other results from the Make UK survey included:

37% of manufacturing companies reported a worse cash position in October 2021 than prior to the pandemic. However, the survey also found an equal percentage of businesses (37%) reporting a better cash position, with the remainder describing their position as unchanged. It reported some differences by industry, with manufacturers in aerospace and automotive manufacturing more likely to be in a worse position.
45% of respondents said liquidity support was a “precautionary measure” and in practice was not required.
Debt servicing was ranked the least threatening of 10 risks to cashflow explored in the survey. The most threatening was increases in input prices.
34% of respondents said their business’ debt or tax liabilities would pose an operational threat in the coming two years.
For firms with reduced liquidity, this most often affected plans for growth. For these companies, cash that would have been used for investment was being diverted to more immediate needs, such as buying parts or paying suppliers and employees. Make UK said this would have continued implications for manufacturing industry well after the pandemic’s passing.

What is the wider economic impact of increased debt?

The Bank of England suggested that financial stability risks have increased “moderately” as a result of higher corporate debt. It said that these will depend on how the pandemic evolves and how policy responds. It highlighted possible wider economic impacts from business failures because of excess borrowing. These included higher unemployment and lower household incomes, with risks to mortgage payments, unsecured credit and the overall speed of the recovery.

In September 2021, the Economist argued that episodes of significant corporate debt defaults “rarely cause significant economic damage”. Quoting an academic paper, it suggested that lenders to indebted companies have incentives to restructure the loans in a way that is not possible for large numbers of smaller, household loans. In addition, the Economist quoted evidence that firms in the most threatened sectors of the economy—such as hospitality—represent only a small proportion of overall corporate debt.

Policy proposals

Professor John Van Reenen, from the London School of Economics, welcomed the Government’s loan guarantees but also proposed other possible policy responses to the increased level of corporate debt. On the existing schemes, Van Reenen said they should be modified in two ways during the recovery from the pandemic. First, he proposed that the generosity of the guarantees should gradually decrease over time, dependent on the state of the economy. Second, he suggested that the use of state guarantees should be linked to restrictions on dividend payments and/or higher future corporate income taxes.

Professor Van Reenen mentioned two other possible policies. First, a ‘UK recovery corporation’, as proposed by the financial sector trade association, CityUK. CityUK proposed this publicly funded body to manage the debt that the Government has guaranteed. CityUK argued that the corporation could:

support funding on more manageable terms for businesses;
provide a vehicle in which the private sector could invest in over time; and
offer viable SMEs the opportunity to convert their loans into other forms of obligation, such as means-tested tax liabilities, preference shares or long-term subordinated debt.

An editorial in the Financial Times in December 2020 also called for consideration of a public wealth fund. It said this could have the power to take direct equity stakes in “stricken” companies.

Professor Van Reenen’s second proposal, which he described as “radical”, was debt forgiveness. He argued that it would provide the best conditions for viable firms to grow. However, he recognised that it would result in a larger impact on the public finances than other options. He also noted that firms might borrow more readily in the future if they believed the debts might be cancelled, but described this as a lesser risk, given the “one-off” nature of the pandemic.

During a Westminster Hall debate on 9 November 2021, Paul Scully, the Minister for Small Business, Consumers and Labour Markets, argued that debt forgiveness, or converting loans to grants, was not consistent with value for money for taxpayers. He said this was because some businesses that had taken loans “did not necessarily need it, but they wanted the extra protection and are still sitting on the money”.

In June 2020, the Federation of Small Businesses called for a guarantee that SMEs would not have to repay loans under one of the government support schemes, ‘bounce back loans’, until the firm was making a profit. Similarly, Make UK called for additional loan payment holidays to be made available, particularly for firms in slower recovering sectors. Make UK welcomed the Government’s ‘pay as you grow’ scheme. This gave businesses the option to delay all repayments from the bounce back loan scheme until 18 months after they took the loans out.

The European economic thinktank Bruegel reported widespread use of national development banks to support businesses in EU countries. It said these offer injections of equity, particularly in start-up companies. However, Bruegel also reported on, and recommended more widespread use of, subordinated loans to SMEs with favourable repayment terms. Subordinated loans are unsecured and, in the event of a liquidation, would be repaid only after other forms of debt. For example, Bruegel reported on a French scheme, in which banks offer such loans and sell portfolios of them to other investors with the French government guaranteeing the first 30% of losses in each portfolio.