The calm before the storm: Early evidence on business insolvency amid COVID-19 - Firebaugh & Andrews

Photo: Fernando Macias Romo / Shutterstock

The COVID-19 pandemic is a human health emergency with profound and wide-ranging economic impacts. Like many economic crises before it, the current recession has caused a marked decline in business activity, interruptions to global value chains, increased unemployment, credit squeezes, and rising government debt levels. It has also caused a liquidity shortfall for both businesses and individuals, weakening their ability to meet debt payment obligations and pushing many into a state of insolvency. 

In light of the bleak financial reality faced by countless firms during the pandemic, questions arise as to whether these businesses can withstand the storm. A recent note by the World Bank Group explores the pandemic’s early impact on formal business insolvency filings and provides predictions as to what can be expected in the medium and long term.

Economic recessions are linked to surges in insolvency filings in both advanced and emerging economies. In early 2020, a rapid consensus emerged predicting a sizeable increase in the number of business insolvencies due to the pandemic’s negative economic impacts. Many expected rates to repeat the escalation of filings experienced during the 2008 Global Financial Crisis. However, the evidence that emerged in the following months painted a very different picture: Formal business insolvency cases dropped in many countries—in many cases, significantly—in the second and third quarters of 2020.

This trend was partly due to the unprecedented level of fiscal support programs and payment holidays implemented by governments and the private sector. Several direct legal interventions also played a role, such as temporary changes to creditor rights, increased barriers for creditor-initiated insolvency filings, suspension of the duty to file for insolvency and related liabilities, and emergency debt enforcement freezes.

Figure 1: Relative Monthly Change in Business Bankruptcy Filings (compared to September 2019), by Country

Image

Yet rates of business insolvencies are likely to increase in the medium and long term. 

Lower sales, higher unemployment, heightened corporate balance sheet vulnerabilities, and enduring liquidity challenges continue to erode business finances and call for insolvency filings for distressed firms. Previous crises have demonstrated that solvency issues, debt defaults, and non-performing loan (NPL) build-up may take several quarters to peak.

Rather than avoiding the wave of business insolvency filings altogether, the evidence suggests that we have merely postponed the coming of the tide to the months and years ahead. Even after COVID-19 vaccines usher in a “return to normalcy” and the easing of social distancing directives, many businesses will likely be compelled to enter into insolvency proceedings  as they fail to regain their footing in the post-pandemic economy.

Governments must confront this upcoming increase in insolvencies by strengthening insolvency regimes and developing agile preventive mechanisms and effective judicial processes.  Doing so will mitigate some of the pandemic’s worst economic effects, ensure sound firms are given a fair shot at survival, and build a more resilient economy to weather future crises.