Corporate Failure and the Impact of Macroeconomic Shocks Dr Gaurav Ganguly, Chief Economist, Atradius Sunil Poshakwale In this environment of global economic uncertainty, I have Dr Gaurav Ganguly who has done work on corporate failures and macroeconomic shocks. Gaurav is Chief Economist at Atradius, a large insurance company based in Amsterdam. So Gaurav, the worst effects of the economic crisis appear to be behind us and 2010 is largely forecast as a year of growth and recovery – in advanced economics, particularly. What does this mean for corporate failures. Gaurav Ganguly Well Sunil, 2009 turned out to be a fairly remarkable year in terms of the economic history of advanced countries. Every single one of them displayed a contraction in economic activity. In some cases this turn in the cycle was evident already in 2008 with GDP moderating and various countries such as Italy and Japan already leading the way for 2009. The turn in the insolvency cycle too was evident in 2008. In several countries we saw GDP moderating, we saw insolvencies increasing – sometimes by 25 to 30 per cent. Then came 2009, which I guess could really be regarded as the mother of all insolvency years. We had insolvencies increase in excess of 70 per cent year on year in The Netherlands, and close to 60 per cent in Denmark and various other countries saw insolvencies rise by something like 25 to 30 per cent. Now 2010 is largely being forecast as a positive year. We seem to have the worst behind us and we seem to be set towards an economic recovery. Now, this should be good news and certainly implies that levels of insolvencies will fall across many countries. However, we cannot expect that these levels of falls will be dramatic and in some cases they may even continue to rise. Work that we do on forecasting insolvencies would suggest that we can reasonably expect to see an increase in insolvencies in some countries like France and Germany, while in the UK we might expect to see the same level of insolvencies as we experienced in 2009. In other countries where we do see a more benign macroeconomic climate we would say that yes, insolvency levels will go down, but possibly not that steeply. We may expect to see only a 10 per cent moderation in the level of corporate failure for instance in The Netherlands or the USA. Sunil Poshakwale You said that experience of countries with regard to insolvencies are driven by country specific factors, yet trade and financial linkages have ensured that this credit crisis has had a common effect, especially on advanced economies again. Economic activity in these Knowledge Interchange Online© Cranfield University January 2010 1 Dr Gaurav Ganguly
countries declined simultaneously, then what is your response with regard to corporate values in these economies. Gaurav Ganguly Yes, you are quite right. I have suggested that countries will face these specific experiences in 2010 and in some cases insolvencies are likely to rise, but in other cases insolvencies might even decline slightly. But you are also quite right in that there has been very much a common effect in terms of the macroeconomic shock that has hit various advanced economies and this is also very much in keeping with the hypothesis of an increased component of the common part of business cycles. That being said, I think there is a fair case to be made for the heterogeneous response of insolvencies and even the heterogeneous impact of macroeconomic shocks. Going into this credit crisis certainly we observed a certain amount of heterogeneity at the rate of which economies succumbed and the incidence of corporate failure in these countries. We have seen increases in corporate failure in Denmark in 2008, whereas in Germany we saw a very negligible increase in corporate failure at the same time. In 2009 we saw increases in corporate failure fairly much across the board; but in 2010, as we come out of this recession hopefully, it does not necessarily mean that all countries will see declines in the incidence of corporate failure. Just as much as they displayed heterogeneity on the way in, we have good reason to believe that they will display heterogeneity on the way out. And in fact, as I mentioned earlier, we would actually reasonably expect to see insolvencies continue to increase even slightly in certain countries. Now there are a number of reasons why this might happen and it would certainly be interesting to study this in greater detail to understand country specifics and the extent to which they drive this heterogeneity in corporate failure. One can easily think of a number of reasons why this might be the case, indeed, such as the size distribution of firms or the economic structure of countries or even the legal and institutional features around default. Sunil Poshakwale What then is your view about the uncertainty surrounding your forecast for 2010? Are there scenarios under which corporate failures might start to increase or indeed decrease? Gaurav Ganguly One could certainly think of a very positive scenario in which growth becomes firmly entrenched; the problems facing the financial system abate rather rapidly and the world moves back out of quantitative easing and a zero interest rate environment into positive economic growth and moderate inflation. We could also Knowledge Interchange Online© Cranfield University January 2010 2 Dr Gaurav Ganguly
even, perhaps, predict this might happen within the next three to six months. However, I would have to argue somewhat forcefully perhaps that this is an event that has very low probability associated with it. Instead I see some fairly large risks that could impact on the central scenario. Now a central scenario, as I mentioned to you, was one in which corporate default would indeed decline in many countries though perhaps not very strongly. One reason we don’t believe it will decline very strongly is that the economic environment, even though improving, is by no means yet totally benign in the way in which it was in say for instance 2005 or 2006. In fact given the fall that we experienced in 2009 one would have to argue that we are facing an improving, but certainly far from benign, economic climate as a result of which economic failure, macroeconomic shocks will persist and corporate failure will indeed still be high. Despite this it could get worse; there are a number of reasons why it could get worse; and I can think of four easy examples of real criteria that could drive a higher rate of corporate failure in 2010. For instance, we have issues like fiscal spending, quantitative easing; we have the credit availability; and we even have possible financial market corrections that could drive this process further. For instance, we have had a large amount of discretionary fiscal spending in 2008 and 2009 conducted by many major governments in advanced economies. And while the amount of spending has varied and the impact is also arguably different, as is the timing, what we certainly know is that there are plans afoot to scale back these discretionary spends. What is likely to happen once it tails off? Is it likely to lead to the resumption of consumption in business investment or is it simply likely to result in a temporary pick up of economic activity, which then tails off again? Quantitative easing is a similar problem. Central banks are now outlining the exit strategies for exiting quantitative easing, but once we exit quantitative easing that might not still solve the problems that the banking sector is facing and certainly does not necessarily mean that credit becomes cheaply available even after we exit quantitative easing, while at the same time we have problems of approaching inflation. Hence getting the timing right for quantitative easing will be just as crucial as the magnitude of quantitative easing. If we get this wrong then the economic shock that could follow could easily lead to a higher incidence of corporate Knowledge Interchange Online© Cranfield University January 2010 3 Dr Gaurav Ganguly
failure. A third point I would argue would be financial market corrections; that we have seen some very strong gains in financial asset prices this year and it is debateable as to what extent this has actually been matched by increases in real economic activity and to what extent this has perhaps been speculative behaviour, helped along by the low interest rate environment. If this happens to reverse and asset prices then correct further, this could have a knock on effect onto the financial system and to collateral values and once again feed back into real economic activity and corporate failure. Finally, even if we do have a pick‐up in economic activity we could find that firms are facing constraints when they go and start increasing the demand for credit if they find that the financial sector is non compliant. So I am afraid there are some very large risks out there which could negatively impact on the incidence of corporate failure which would come back a haunt our central scenario. Sunil Poshakwale Gaurav, thank you very much for sharing your research with us. Gaurav Ganguly Thank you. Knowledge Interchange Online© Cranfield University January 2010 4