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Economics Weekly - Why are corporate default rates so low in the UK? Weekly economic data preview - Central bank rate decisions poised to keep markets on their guard...
Economics Weekly 6 September 2010
Why are corporate default rates so low in the UK?
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. What factors account for why this outcome has not materialised? 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. Falling demand might have combined with financial market uncertainty to reduce funding avenues and so led to greater company defaults. 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 worse than 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. Hence, for now, the trend in defaults is pointing down not up. This is despite the debt to income ratio moving up, 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. 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. 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 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.
Chief Economist, Corporate Markets
Weekly economic data preview 6 September 2010
Central bank rate decisions poised to keep markets on their guard...
The highlight of the week in the UK is the Bank of England policy announcement on Thursday when we expect both the level of the bank rate and the size of the QE programme to be left unchanged at 0.5% and Â£200bn, respectively. However, the recent run of poor data, such as the PMI surveys and various housing market indicators, may reignite the debate about whether further policy easing is required to revive a faltering economic recovery. If, as we expect, growth shows sharply in the months ahead then options for further stimulus are likely to start dominating the MPCâ€™s policy agenda. In terms of economic data this week, we expect to see a small decline in Julyâ€™s manufacturing output number (although this follows rises in four out of the last five months), and a marginal deterioration in the visible trade deficit. Finally, the annual rate of producer input and output price inflation should show a further moderation in August.
ô€‚„ Following the recent ECB interest rate decision and extension of liquidity measures designed to assist the banking sector, this week sees a quiet eurozone economics data calendar. Of most interest will be the series of industrial production data releases for July, starting with German output figures on Wednesday. Here, our forecast stands at +0.8% m/m with factory orders due the previous day (our projection is +1.0% m/m). Driven primarily by export activity, business survey data in Germany have consistently shown signs of strength. Elsewhere, equivalent production data are published in France, Italy and Spain with aggregate eurozone numbers due next Monday. The industrial output data will provide important guide as to the entry point into the pace of GDP growth in Q3.
ô€‚„ It is also a relatively quiet week for US data, with markets closed on Monday for the Labor Day holiday. Following a startling $7.9bn jump in the deficit to $49.9bn in June, arguably the highlight is July trade data on Thursday. A weaker dollar has the potential to support exports but the performance of imports is again likely to have the bigger say. We look for a slight narrowing in the overall trade deficit to $47.5bn, but with the risk of a bigger decline should imports revert back towards their 3-month moving average level. July wholesale inventories data on Friday will also help to refine estimates for Q3 GDP. We forecast a 0.4% gain, underpinned by our opinion that the inventories/sales ratio should have further to rise. As usual, the weekly initial claims will draw attention on Thursday. In other events, the Treasury will sell $67bn of notes this week.
ô€‚„ A number of central banks will meet this week. Despite the solid Q2 GDP result, we expect that the RBA will keep the Australian interest rate unchanged at 4.5%. Although, a rate rise in October cannot be ruled out, we expect the bank will keep rates on hold until after the next CPI release later that month. We forecast the cash interest rate will end 2010 at 5%. Both Canada and South Africa are also expected to keep their interest rates unchanged at 0.75% and 6.50% respectively. Nonetheless, there are a number of risks surrounding these forecasts. In particular, given the recent weak monthly survey data and benign July inflation result, the market is expecting the SARB will cut its benchmark by 50 basis points. However, while we acknowledge that there is a substantial chance that rates will be cut, we believe that given current wages growth there is a significant risk that inflation expectations will shift sharply higher, which could warrant a prompt reversal in policy in the future. In contrast, a further rate hike in Canada cannot be ruled out.
Economic Research team
Lloyds TSB Corporate Markets Economic Research, 10 Gresham Street, London, EC2V 7AE, Switchboard: 0207 626 1500. www.lloydstsbcorporatemarkets.com Bloomberg: LLOY<GO>
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