Rise in insolvencies could impact credit market

In most advanced economies, corporate insolvencies have been significantly depressed. Access to credit and other government support measures have kept many businesses afloat. All this support has led to corporate insolvencies decoupling from other economic markers like GDP growth and unemployment, according to the Bank of International Settlements’ (BIS) latest annual report.

“Loans and guarantees shielded firms,” said Agustín Carstens, general manager of the Bank for International Settlements (BIS). “Corporate bankruptcies did not spike as many had predicted. Scarring of households and firms was limited.”

For example, based on statistics from the Insolvency Service in the UK, only one month (December) saw insolvency rates higher than what they were in the previous year (i.e. December 2019) in the 12 months since the first lockdown. The pent-up demand of consumers will be a determining factor in the size of an insolvency spike once support measures are eased.

“The strength of these forces will help determine whether the wave of business insolvencies that failed to materialise last year eventually occurs,” Carstens said.

A potential rise in insolvencies could also have a magnified impact on the credit market, said the report. While most banks have the capital reserves to face a severe downturn, a rise in insolvencies could put pressure on capital buffers, limiting the ability of banks to supply credit and may moderate investment.

Even if this scenario does not come to pass, many corporates have built up cash reserves, either through loans or drawing on credit lines and will have higher debt obligations. This would potentially have a similar dampening effect on investment.

“Constrained financial institutions and highly indebted firms could also delay the required reallocation of resources,” the report noted. “Such a reallocation would be more pressing in this scenario, given the persistent changes in consumer behaviour and increased risk of ‘zombie’ firms linked to the sustained downturn.”

Inflation remains “transitory”

With inflation remaining a key concern for many economies, the BIS has reiterated what many central banks have said, higher inflation rates are “transitory”.

The “central scenario” outlined by the report predicts that inflation will only be temporarily above central bank targets, with corporate losses limited and a smooth sectorial reallocation.

“The central scenario contemplates higher inflation but [where] it doesn’t go out of control,” said Carstens.

“Many of the increases in the price level that have been affecting measured inflation are temporary factors, base effects, relative price increases and adjustments in prices that are related to supply chains.”

As forecasts of recovery for advanced economies become more optimistic central banks are signalling they may start raising interest rates sooner than initially expected. The Federal Reserve has indicated interest rates could rise as soon as 2023, the Bank of Canada even earlier with money markets in the UK similarly expecting a hike in late 2022.

Though low interest rates make debt servicing cheaper, Luiz Awazu Pereira da Silva, deputy general manager at the BIS said eventually returning to higher rates would create a more robust economy.

“We don’t want interest rates to remain as low as they are,” he said. “It’s important that real interest rates in particular are positive, so that we have a healthier economy and capital can be allocated more effectively.”