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Economics Weekly

Will corporate defaults in the UK rise as much as feared?

Thu, May 8 2008, 06:24 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Financial markets are worried that UK defaults will rise sharply…
In the Q1 2008 Bank of England Credit Conditions Survey (CCS), there was a jump in lenders’ expectations that default rates on loans would rise sharply, see chart a. The chart highlights that there was a greater number of respondents expecting defaults to increase in Q2 than in Q1, which in turn was much worse than in Q4 2007. This is the main reason there was a rise in the cost of lending, to companies and households, to compensate for the higher risk of defaults. It was also one of the reasons why there was a further tightening of credit criteria before a loan is made and a cutting back of the supply of loans being made available. How likely are these fears about defaults to be realised?

...but the data for Q1 2008 were reassuring on this score
The evidence from UK insolvencies in Q1 was rather more reassuring than that suggested by the expectation of lenders in the CCS and also implied by corporate credit spreads, see chart b. This chart shows that the spread of lending to UK companies over safer government bonds implies a sharp rise in corporate failure rates, at least back to the long run average of around 1.4% of companies on the active register against the current failure rate of 0.6%.

Data for UK insolvencies in Q1 show a rise of 2% in the number of companies in liquidation during the quarter and an increase of 4% on the year before - the highest figures since 2006. For individuals there was an increase of 1.7% in insolvencies on the quarter before but a fall of 13.2% on the same period a year ago. On the surface, this would validate the rise in defaults expected by lenders in the CCS and reflected in corporate spreads as shown in charts a and b. But charts c and d show that the changes in Q1 UK insolvency data were relatively modest. What can explain this?

First of all, the increase in the number of companies that failed in Q1 was just 64, nine months into the credit crunch. Moreover, the rate of corporate insolvencies is still very low by historical standards, see chart e. Further, the number of company insolvencies would have to rise by nearly half to reach 2001 levels and then more than double to reach the 1990s peak. For households, the rise in insolvencies was 1.7% but this was just 410 more than in Q4 2007. However, the level of individual insolvencies is at very high levels, see chart c, and could reach new peaks if economic growth were to weaken as significantly as the gloomiest forecasts suggest. This is, of course, the great fear, fed by the fact that this early in the economic cycle there are already signs of rising defaults. The worry is that the figures do eventually mirror the worse concerns reflected in credit markets about the crisis and in expectations that the economic slowdown will be as severe as in the 1990s. But how likely is this to be the case?

However, it is still early days and the more pessimistic views could still be right…
Looking at the relationship between the economic cycle and company defaults, see chart f, highlights that there is indeed a strong link between the economic cycle and insolvencies. And that link is almost coincident, that is, as economic growth slows, company default rates start to rise at almost the same time. So there are legitimate reasons for concern about what will happen to defaults if economic growth were to fall sharply. But economic growth in the UK was 0.44% in Q1, and 2.5% higher than the year before. Employment is holding up, manufacturing output is expanding, and though there are some signs of weakness, there are no signs of impending recession.

…but there would be a very sharp rally in a range of financial markets, if the UK's economic performance turns out to be better
Hence, as chart f shows, even if economic growth slows to the 1.6% consensus view, then corporate defaults will be significantly less than the financial markets are expecting to occur. In turn, this implies that there could a big rally in company shares and in the shares of lenders to them, if this turns out to be the case. Moreover, there would be a narrowing of corporate spreads and a sharp reduction in credit risk attached to lending to the UK corporate sector. But this outcome is still some way off, and it will take convincing signs that the UK economy is not heading for recession for the current negative trends in credit conditions and corporate spreads to unwind. However, by the second half of 2008, all of this will be much clearer.

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Published on  Thu, May 8 2008, 06:29 GMT

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