Much of Europe rang in the start of 2021 with new lockdowns and weak economic activity. This same period saw the roll out of effective vaccines. While the end of the pandemic will remain a race between the virus and vaccines, there is now light at the end of the tunnel.
At the same time, government programs aimed at supporting lives and livelihoods have been highly successful. Amid the pandemic's enormous human toll, these measures provided critical lifelines to people and have preserved the structure of the economy and the income of workers. The massive policy support saved millions of European firms, accounting for over 30 million jobs.
However, as the pandemic persists and measures—such as loan repayment moratoria—expire, bankruptcies could rise, leading to a surge in unemployment and nonperforming loans.
To support a rebound and strong recovery in 2021, emergency programs and lifelines will need to be maintained, but they also need to adapt.
Europe now needs to gradually change the support to firms from providing liquidity toward strengthening their equity.
Relief policies for businesses
Almost a year into the pandemic, many European companies, especially micro and small enterprises in high-contact sectors, continue to reel from the shock of Covid-19. With containment measures preventing many firms from operating at full capacity or at all, government support programs—such as job retention schemes, which at their peak benefitted 54 million people—have been essential for businesses and people to survive. Liquidity (ready cash) provided to companies prevented cascading bankruptcies. It allowed banks to extend loans rather than amplify the downturn by adding a credit crunch.
In a recent IMF staff study (see presentation here), which covers 26 European countries (of which 21 are EU members), we estimate that without policy support, the share of illiquid firms in Europe would have more than doubled and that of insolvent firms would have almost doubled by end-2020.
But many companies are still short of equity
Public support so far is estimated to have filled 60 percent of European firms' liquidity needs because of the Covid-19 shock, but only 30 percent of the equity shortfalls (the extent to which firms' debt exceeds their assets). Even with this scale of support, the share of insolvent firms as a share of total firms is estimated to have increased by 6 percentage points. Equity shortfalls are largest for micro firms and small businesses, with current policies absorbing only one quarter of the equity gaps versus over two fifths for larger corporations.
Without additional equity support, some 15 million jobs are at risk. About 2 to 3 percent of GDP will be needed to close the equity gap and provide firms sufficient equity so they would no longer be in difficulty, focusing only on the firms that were solvent before Covid-19. Both private and public sector action is required.
How can this be done?
Liquidity support cannot address equity shortfalls. Policymakers will have to move the dial from debt-increasing liquidity support to more equity support for those firms that have good prospects after the pandemic.
Individual countries are coming up with innovative equity programs, but they face many implementation challenges. The public sector is not well placed to assess the viability of a large number of small businesses nor to monitor their performance. This will involve avoiding that public support is more attractive for bad than good firms—adverse selection—and preventing firms from mismanaging their business once they have received state support—moral hazard. Targeting support—something that is hard to do—will be critical to avoid wasting taxpayers' money and should be improved. Mechanisms that target firms more accurately are likely to be more complicated, reducing take-up and timeliness of the aid. Another difficulty is how to ensure that the private sector does its part.
Involving banks, which know their clients and routinely assess business plans, is an important principle that can help address adverse selection. Incentivizing private investors to contribute equity mitigates moral hazard. Here are some examples:
- France's proposed program of participatory, subordinated loans envisions a central role for banks in selecting viable firms and retaining a share of these loans on their books—ensuring "skin in the game."
- In Italy's program for small and medium-sized enterprises, private equity injections are encouraged by tax incentives and the government's contribution is capped to a fraction of the private investors' capital increase, who have to remain invested for some years.
- Adequate contributions and burden sharing by investors is required by Ireland's support scheme for small businesses, whereby Enterprise Ireland—a government agency—assesses firms' plans to restore long-term viability with the help of market appraisals.
Healthier firms, stronger recovery
Europe now needs to gradually change the support to firms from providing liquidity toward strengthening their equity. For those firms that have to restructure debt or be liquidated, out-of-court debt restructurings and insolvency regimes will need to be enhanced. Healthier firms will forestall a return of "doom loops" between Europe's real and financial sectors. Most importantly, healthier firms will create more jobs. Upskilling, training, and job search programs should help displaced workers find new jobs in sectors that are expanding. Countries will also need to invest in the green and digital transitions to boost resilience and productivity. This course of action will ensure a strong and lasting recovery after the pandemic.
Alfred Kammer is the Director of the European Department at the International Monetary Fund
Laura Papi is Assistant Director in the European Department of the International Monetary Fund
Disclaimer: This article first appeared on IMF Blog, and is published by special syndication arrangement