Why are corporate default rates so low in the UK?
Mon, Sep 6 2010, 10:39 GMT
by Trevor Williams
Corporate default rates in the UK are exceptionally low for this stage of the economic cycle. The severity of the recent economic shock should have resulted in a rise in defaults bigger than experienced in the last 50 years of economic downturns - or at least on par with some of the worst. They have risen, but nothing like the fall in economic growth suggests they should have. In this Weekly, we present a few reasons why this might have been the case and ask whether low default rates will or can persist going forward.
One of the reasons for expecting a higher level of corporate defaults than is currently being seen is that this recession is associated with one of only 15 episodes out of a total of 122 where an economic shock has been accompanied by a financial markets crisis in the last 100 years. Experience shows that these twin shocks cause greater economic upheaval than a single shock and result in economies taking longer to recover to their previous growth path. Therefore it would have been no surprise to have seen record company default rates as a result of these twin shocks. But the reality has not turned out to be like this.
Chart a shows that the relationship between insolvencies and economic growth is inverse, and powerful. This is to say that as economic growth declines, company defaults worsen, sometimes more than is implied by the fall in GDP. Take the 1990s downturn for instance, the corporate default rate (the number of insolvent companies as a share of those on the total active register) rose from around 1% at the end of 1988 to 2.7% by the end of 1992. On any measure that is quite a move, and then it stayed at that level for almost a year before gently beginning to fall back. It took a further decade before the default rate fell to or below the level reached prior to that recession.
Compare that experience to the current one, where the corporate default rate has risen only modestly from its 2007 low. Had the corporate default rate moved in line with the GDP decline during this recession, it would have at least matched the rise seen after the 1991 downturn, a rate of 2.7% of active companies. Assuming, however, that it moved in the same way as it did in the 1992 recession, then the default rate would now be heading towards 3% plus of active companies. Instead, the rate stands at less than 1% of active companies and has moved down, not up, in recent quarters. This is despite the debt to income ratio rising sharply, see chart b, as would be expected in a recession as severe as the one the UK has just experienced. On its own, the debt to income ratio implies that insolvencies should have peaked at close to 3% of active companies.
Taking the income side of that gearing ratio, and so looking at company profits against the corporate default rate on its own, see chart c, suggests that, as a lead indicator of defaults in the past, the improvement now underway is not by itself a surprise. After all, the debt to income ratio is now falling and that is consistent with a drop in default rates. That said, this outcome has to be set against the fact that this same profit growth variable suggested that defaults should have risen to at least 2% plus before any improvement occurred. So what accounts for the fact that the UK corporate default rate did not rise as much as would be expected by the economic downturn and is now falling as the economy recovers from recession?
The short answer is that the sharp fall that has taken place in interest rates, both long term and short term, see charts d and e, are the overwhelming reason why default rates have remained low. With price inflation low, the UK monetary authorities were able to cut official short term interest rates to the lowest since the Bank of England was formed in 1694. In every post war downturn the UK has experienced, inflation has played a major role, either triggering the recession through higher official interest rates or by preventing them from being cut. As a result, in these recessions, default rates rose to very high levels, roughly trebling from levels prior to the onset of the downturn. But not this time. Low price inflation allowed monetary policy makers the use of the interest rate weapon that was not available in earlier downturns. Of course, fiscal policy has also been loosened in this recession, keeping credit lines open and so contributed immensely to stabilising the economy and hence bore down on company default rates.
Our projection for company defaults in the next few years, based on GDP, the output gap, debt to income ratios and interest rates, suggest that in theory if official interest rates stay low until the economy is recovering in a sustainable manner, company defaults can actually fall further. In reality, the fall in default rates will come to an end when interest rates rise significantly or are expected to rise. Having said that, the good news is that by then the recovery will be more entrenched and so there will be much less reason for firms to fail. Our analysis suggests that part of the debate about when to raise interest rates should take into account the impact it could have on company defaults and so the sustainability of the economic recovery if business confidence is hit as a result.
