According to the European Commission, after having exhausted these buffers, between 25% and 35% of EU companies would experience a liquidity shortfall, in a range between EUR 350 and 500 bn. It could concern 180 000 – 260 000 companies employing between 25 and 35 million people[2]. Should it become increasingly difficult to cover the liquidity shortfall by means of a combination of recapitalisation and additional borrowing, the problem would spill over to the household sector, via an increase in unemployment.
Although meeting the financing needs would avoid a negative spiral of losses leading to labour shedding, a decline in consumption and more losses for companies, there could still be a drag on growth if corporate leverage stays very high[3]. A key channel of transmission works via corporate investment. Companies with a high gearing could find it difficult to obtain loans to finance investment projects, or could face higher borrowing costs or stricter covenants. Management could also become more cautious so as to avoid that investments, which would end up not meeting expectations, would put the company at risk. However, the opposite arguments can also be made. When interest rates are low, the quest for yield will force investors to accept ever looser lending standards by investing in covenant-lite loans. Managers of highly geared companies might adopt an all-or-nothing attitude and make riskier investments when their compensation depends on share price performance. When the net effect is theoretically ambiguous, empirical research can provide the answer. A Bank of England working paper has found that during the global financial crisis and the recovery phase which followed, cash-rich companies in the UK invested significantly more than cash-poor firms: “having a liquid balance sheet when the credit cycle turns thus gives firms a competitive edge that lasts far beyond the crisis years”[4]. Recent research[5] based on firm-level data shows that during the eurozone sovereign debt crisis, firms with higher leverage reduced their investment more than others, even more so in the peripheral countries. This negative effect lasted for up to four years after the crisis and explains about 40 percent of the observed decline in corporate investment.
