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Corporate debt.

A topic of some current interest to forecasters and policymakers is the extent to which the high levels of corporate indebtedness observed throughout the late-1980s contributed to the recession and whether the still substantial debts of the corporate sector are likely to make the recovery from recession slower than normal. The purpose of this note is to present and provide an interpretation of the evidence bearing on this issue.

That corporate debt was built up to historically high levels in nominal terms is illustrated by chart 1 which shows two measures of the nominal indebtedness of industrial and commercial companies (ICCs): net debt is a broad measure of company debt including debenture and loan finance and net trade credit as well as net indebtedness to banks, net liquid debt is bank advances less identified liquid assets. (Precise definitions are given in the appendix). Of more importance is the fact indicated in chart 1 that the level of debt when measured in real terms has also reached unprecedented levels in recent years.

Despite this substantial increase in the indebtedness of the corporate sector, current levels of company debt are not unprecedented when considered in relation to nominal output or to the value of the capital which provides the means of servicing the debt. Chart 2 shows the value of net debt relative to the market value of the ICC sector (as measured by their net financial liabilities) and to the measured value of the net capital stock at current replacement cost. This suggests that at the end of 1990 (the latest date for which figures are available) the level of corporate indebtedness in relation to the overall market value of ICCs is at about its average for the last twenty years. By contrast capital gearing indebtedness in relation to the measured value of the capital stock) has risen sharply throughout recent years although the level at the end of 1990 is not especially high by the standards of the past twenty years. The explanation for the more substantial rise in net debt in relation to the capital stock when compared with its rise relative to market value is that while a large proportion of capital accumulation has been financed by borrowing it has been accompanied by a rise in the market value of capital relative to its replacement cost: the valuation ratio has risen. The proximate cause of this is the steady rise in real equity prices throughout the 1980s shown in chart 3.

The viability of an individual company is best measured by the relation between its net debt and its overall value: if the company's debt is low relative to what the market believes it to be worth then it should not have much difficulty in raising any new finance that it might require. The evidence therefore suggests that the ICC sector as a whole is not in a serious financial state relative to recent historical experience. But there are at least three caveats to this. First the overall picture can mask severe problems for particular companies. That this is the case is well illustrated by the large number of company liquidations observed recently (see chart 4). Second there is a large degree of uncertainty surrounding estimates of the value of capital whether derived from direct estimates of the replacement cost of existing capital or indirect estimates based on the capital market valuations. If the capital stock has been overestimated since the last recession in 1981 because of under recording of scrapping at that time") then measured capital gearing will now underestimate the true level of capital gearing indicating that the true balance sheet position of the ICC sector is worse than the figures suggest. Third the satisfactory levels of aggregate corporate solvency rely on continued good performance from the stock market. Should equity prices fall sharply for one reason or another, the level of corporate debt will look large in relation to market valuations and this would cause problems in the refinancing of debt.

This is important because the liquidity position of the company sector appears much worse than its solvency position. Chart 5 shows the level of income gearing to have been at a record level at the end of 1990 and while improving to remain at a much higher level than has been the case historically. This aggregate pattern no doubt obscures much more unhealthy positions at the disaggregated level. The reason for the poor liquidity position is the unusual combination of high interest rates and high levels of real indebtedness: high debt in the late-1960s was combined with low nominal interest rates while high nominal interest rates in the early- I 980s were associated with relatively low levels of debt. The only precedent for the current combination of capital gearing and liquidity gearing is that observed towards the end of 1974 when the situation was considered serious enough for stock relief to be introduced. However the situation then was undoubtedly much less stable than now partly because inflation was so much higher but also because debt levels in relation to market values were at more than double their current levels (see chart 2) thus making the solvency of companies much more doubtful.

Having to some extent set out the facts relating to corporate indebtedness it is now worth setting out some of the arguments as to why this might matter to individual firms in the economy. A more complete description of the individual firm's choice of capital structure is given in Young (1991). It is useful to consider two types of firms: those that are recognised as being solvent and those that are in danger of insolvency.

Consider first the case of a solvent firm. The level of debt carried by the firm is something that it has itself chosen in the light of its expectations about factors such as the future level of demand for its product and interest rates. It must be assumed that providing events proceed as had been expected then the firm will not regret having chosen the level of debt it carries its behaviour is dynamically consistent). In a similar vein Sargent (1991) has noted that the observed increase in indebtedness by ICCs was incurred in what can hardly have been a fit of absence of mind rather than the exercise of a rational preference'.

Suppose now the environment becomes tougher in that demand turns out to be lower than expected and interest rates turn out to be higher than expected. The firm can therefore be expected to recalculate how much it intends to produce, how much capital it needs and how to finance it. Clearly in doing this the firm will not be able to alter commitments it has made on the basis of expectations that have turned out to be false. The question that needs to be answered is whether the real outcome for the firm is its capital, employment and output decisions) is affected by the level of debt it has accumulated. The firm will regret having made some of the investments made when its expectations were over-optimistic and the way in which these investments were financed, but it is not clear that this will affect its real decisions from now onward: bygones are bygones. One possible effect comes about because its debt will be higher in relation to its market value so that it will need to pay a higher price for debt capital. But this will tend to encourage the firm to alter its debt equity ratio by substituting equity for debt and will not necessarily exert any influence on its real decisions.

Therefore the likely financial response of a solvent firm which revises downwards its view of current prospects is to attempt to reduce its debt equity ratio. At the same time it will probably reduce its investment plans because past mistakes have left it with too much capital. But the paring back of investment is not a consequence of the attempt to reduce indebtedness, instead it arises from the worsened economic outlook.

Other firms will not be in such a fortunate position and will find that their indebtedness is so high relative to their market value that they are unable to raise further debt capital. In such a situation it is unlikely that they will be able to raise fresh equity because much of this will go to the firms creditors with no gain to the new shareholders. This together with a difficult liquidity problem caused by high indebtedness is likely to ensure that the actions of such firms are strongly affected by their outstanding stock of debt. There are two possible outcomes. First liquidation. Second managing to avoid liquidation by taking action to improve their cash flow and balance sheet position. This can be accomplished by cutting back on discretionary expenditure such as dividend payments and investment and by meeting demand by selling off stocks and thereby reducing the variable costs of production.

In some sense it is the firms who continue trading while in financial difficulties who pose the biggest threat to aggregate levels of activity. The business of companies that are liquidated will tend to be taken up by solvent companies who either buy the bankrupt business or take over its customers. This then eradicates the debt problem from that business and passes it on to its creditors. But for companies close to bankruptcy the debt problem is present and likely to have a large influence on their investment, employment and stockholding. Of course company liquidations will cause further problems downstream: banks needing to make extra provisions for bad debts and companies not receiving payment for goods and services already supplied. The overall effect will depend on the balance sheet position of those affected.

It is undoubtedly the case that a number of companies are in financial distress and cutting back on employment and spending. But this does not imply that aggregate investment, stockholding and employment in the sector have been lower than they would otherwise have been with less indebtedness. For example, in a competitive economy the reduction in investment by the financially distressed companies will be made up by higher investment than otherwise by the financially sound firms who respond to lower prices of investment goods. Thus there is no necessity for greater corporate indebtedness to lead to a lower level of aggregate investment in response to the financial distress of some of the firms in the economy. However it appears unlikely that this argument is of any empirical relevance in the short term. Some quantification of these aggregate effects can be obtained from the Institute domestic model.

Econometric equations for investment, stockbuilding, employment as well as some of the financial variables in the Institute domestic model contain terms in the amount of disequilibrium net liquidity held by the company sector. This is measured as net liquidity (the negative of net liquid debt shown in chart (1) less desired net liquidity as represented by an estimated relationship depending on money income, inflation and interest rates. (For more details see Wren-Lewis (1988) and Ireland and WrenLewis (1989)). In recent years the estimated level of disequilibrium net liquidity has been large and negative thus implying lower investment, employment and stockbuilding than otherwise. But because of developments not accounted for by the relationship determining desired net liquidity (such as financial liberalisation) it has been judged in some previous forecasts that the disequilibrium is smaller than the equations on their own would predict. As a consequence the forecasts have shown more activity than would have been the case without adjustment. It is therefore a useful exercise to go back to a previous forecast and to calculate how the forecast would have been different if the estimated levels of desired net liquidity had been derived solely from the model equations.

In the November 1989 forecast adjustments were made to the model equations to reduce the size of disequilibrium holdings of net liquidity by about E8000 million to a level of about L25000 million. Without this change the forecast for employment by the end of 1990 would have been 66,000 lower, that for investment 0.3 per cent lower, that for output 0.15 per cent lower and the stockbuilding forecast would have been about E250 million lower on average throughout 1990. Since that forecast was made the model equations for investment have been changed and include stronger effects from disequilibrium net liquidity and a similar change would now be expected to reduce the investment forecast by about 2.5 per cent by the end of the first year and there would be a correspondingly larger reduction in the output forecast of about 1/2 of 1 per cent.

The decision taken at the time of the November 1989 forecast to make adjustments to estimates of desired net liquidity contributed to a forecast of overall activity that turned out to be too high. This does not necessarily mean that this particular forecast judgment was incorrect: the failure to foresee the full extent of the downturn in activity in 1990 was the result of a number of forecast judgments which in combination produced an over estimate of activity. Nevertheless more recent forecasts, including that published in this Review have tended not to adjust the model equations so that the effects of estimated disequilibria in company sector net liquidity have been fully taken into account.

In terms of the structure of the model, the difficult empirical question is in determining how much of the current deficit in net liquidity is desired and how much is likely to prompt some real adjustment. More generally the difficulty is in determining the extent of financial distress within the company sector and how this is being dealt with.

The clearest evidence on this is given by the pattern of company liquidations. It is likely that the number of firms close to bankruptcy is correlated with the number of liquidations. However the number of companies going into liquidation is not necessarily a guide to the size of these businesses or the likely effect on the economy. These are likely to be mainly small companies and will therefore represent a smaller share of the company sector by value than by their share in the total number of companies which is in any case small (about 1/2 of 1 per cent per quarter).

Other evidence is more difficult to interpret. Chart 6 shows the aggregate dividend payout ratio. This reached a peak at the beginning of 1991 but has fallen back since. This might be taken as evidence of financial distress in the company sector although it should be remembered that even solvent companies might wish to reduce their indebtedness following the type of shocks experienced by the UK economy and one way to accomplish this is by reducing dividend payments. Furthermore the chart suggests that dividends remain at a high level in relation to cash flow and indicates that there has not been the type of collapse in dividend payments that might have been expected if the company sector as a whole were under severe pressure. Against this is the fact that weak companies who do not wish to acknowledge themselves as such will wish to avoid a reduction in dividends because of the signal it will send to creditors.

Chart 7 shows the ICC sector financial deficit as a proportion of nominal output. The deficit reached its peak in the second half of 1989 and has since been reduced substantially although companies' need for external finance remains high compared with the historical average. As with dividends this evidence is not clearcut as it is consistent with what would be expected from both solvent and financially distressed companies in the current conjuncture.

Chart 8 shows net equity creation by ICCs. This is defined as issues of ordinary shares less investment in UK company securities. The chart shows that in recent times net equity creation has been close to zero. This is an improvement on the more recent past when it contributed to the borrowing requirement. Chart 9 shows bank borrowing by ICCs as a proportion of nominal output and indicates a substantial turnaround from its peak in the third quarter of 1989. Again this pattern is likely whether firms are in difficulties or not. The evidence from charts 4-9 although ambiguous is consistent with the notion that there might be a number of companies in financial difficulty who are attempting to restore their financial position by reducing investment, stockholding and employment. But as shown in chart 10 the level of investment expenditure remains high by historical standards although it has fallen by about 17 per cent from its peak in the first quarter of 1990. It is possible that this represents nothing other than the response of investment to a downturn in activity and is unrelated with the levels of corporate indebtedness. Indeed the investment equations in the model show no significant evidence that investment is being overpredicted by the normal relationships as would be likely if the influence of indebtedness were larger than is already being allowed for by the disequilibrium net liquidity terms.

In summary it is likely that the high levels of corporate indebtedness observed in recent years contributed in some way to the recent decline in corporate spending although it is difficult to quantify this contribution. The effect has probably been quite small. As to prospects, the main drag on corporate activity is likely to come from the fact that the company sector already has sufficient capacity to meet likely levels of demand over the near future and so will not be rushing to expand capacity. But there are risks on the financial side. Base rates have fallen by 4-5 percentage points since October 1990. Other things being equal this will ease corporate liquidity problems. But to the extent that banks have been increasing their margins to take account of greater default risk, this may not be fully passed on to companies. In addition real interest rates have not fallen to the same extent as base rates and while nominal interest rates are of most relevance to a company's liquidity it is real interest rates that are of most relevance to its solvency: high real interest rates reduce the present value of future profitability without affecting the real value of variable rate debt. Should the stock market become worried on these or other grounds and mark down the value of companies then many more companies are likely to find themselves in financial difficulties and this could lead to further action to reduce indebtedness and this is likely to involve some fall in spending.

REFERENCES

Ireland, Jonathan and Simon Wren-Lewis (1989), Buffer stock money and the company sector', National institute Discussion

Paper no. 151. Sargent, J.R. (1991), Deregulation, debt and downturn in the UK economy', National Institute Economic Review, no. 137,

August. Wadhwani, S. and M. Wall (1986),'The UK capital stock-new estimates of premature scrapping', Oxford Review of Economic

Policy, vol. 2, no. 3. Wren-Lewis, Simon (1988), Supply, liquidity and credit: a new version of the Institute's domestic econometric macromodel',

National Institute Economic Review, no. 126, November. Young, Garry (1991), An equilibrium model of company finance and the cost of capital', National Institute Discussion Paper

no.4-new series.

NOTES

(1) Evidence on this is presented in Wadhwani and Wall (1986).
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Title Annotation:includes appendix
Author:Young, Garry
Publication:National Institute Economic Review
Date:Feb 1, 1992
Words:3225
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