How high corporate debt stifles investment (2024)

Paloma Lopez-GarciaAdviser · Economics, Supply Side, Labour and SurveillanceRalph SetzerTeam Lead - Economist · Economics, Supply Side, Labour and SurveillanceRodrigo Barrela

18 January 2023

By Rodrigo Barrela, Paloma Lopez Garcia and Ralph Setzer

Hit by multiple shocks, the corporate sector has increased its debt over recent years. The ECB Blog shows that strained balance sheets could significantly depress firms’ investment in the coming years with negative implications for innovation and growth.

A strong corporate sector is crucial for investment, innovation and eventually economic growth. Currently, the lingering COVID-19 pandemic, the Russian war of aggression against Ukraine and elevated energy prices stress the financial resilience of companies. Firms also remain challenged by the need to finance large-scale green investments. By comparison to larger firms, small and medium-sized enterprises (SMEs) have been particularly affected as they have lower equity. All of this drives corporate indebtedness. Against this backdrop we discuss the implications for corporate investment and answer the following questions in this post: Does high corporate debt act as a drag on investment following economic crises? Is investment by smaller firms more affected than that by larger firms? And when comparing euro area regions, are there differences in the impact on investment of a change in debt?

Negative impact of high corporate debt on investment

A negative link between high debt and investment is well established with several channels at work.[1] High corporate indebtedness implies higher interest expenses and thus less money available for investment. Firms with high debt also find it harder to obtain new funds from external sources due to their higher default risk. Moreover, the desire to repair weak balance sheets leads firms to reduce their debt burden, and thereby forgo investment opportunities.

In our recent study we shed light on the effects of firms’ debt-to-asset ratio on investment (defined as the change in total fixed assets) in the aftermath of crises. We use firm-level data for 14 euro area countries from 2005 to 2018.[2] We define a crisis period as a significant deviation from the historical value-added growth at the country-sector level.[3] Our exercise identifies 195 crises episodes corresponding to 7 percent of the firm-year observations, with the bulk of these episodes occurring during the global financial crisis and the sovereign debt crisis.

We find that investment by high-debt firms is significantly depressed for a long period following a crisis period (Chart). Over the four years after a large economic contraction, investment growth of high-debt firms is some 15 percentage points below that of their counterparts with lower debt burdens. Highly indebted micro, small and medium-sized firms experience a protracted fall in investment post-crisis. By contrast, higher leverage does not seem to influence the investment of larger firms, which typically have easier access to credit due to alternative sources of financing beyond bank financing and higher cash buffers compared to small firms.[4]


Investment response to a contraction in economic activity.

Investment by firm leverage

(Cumulative growth of tangible fixed capital, percentages)

How high corporate debt stifles investment (4)

Investment of high-debt firms by firm size

(Cumulative growth of tangible fixed capital, percentages)

How high corporate debt stifles investment (5)

Negative investment effects differ across European countries

Significant differences exist across countries in terms of the magnitude and persistence of the adverse investment effects. High-debt firms in Southern and Eastern European countries record a more pronounced and protracted fall in investment than their peers in Northern and Central Europe. This finding possibly relates to the absence of an efficient crisis management framework in the euro area, an adverse sovereign-bank-firm nexus or structural and institutional factors, such as the higher prevalence of small firms in Southern Europe or differences in the efficiency of national insolvency regimes. Our results are also consistent with the literature on zombie firms[5] which shows a) that the share of zombies is higher in Southern European countries than in other European regions and b) that zombie firms record lower investment than non-zombie firms. Additional analysis is however warranted to better understand differences in the sensitivity of investment to corporate debt across countries.

Taking a broader view on the whole euro area, we apply the above findings to tentatively assess the medium-term impact of the COVID-19 crisis on corporate investment. The COVID-19 shock led to a drop in euro area value added of 6.5% from 2019 to 2020, corresponding to about three standard deviations of the historical average. Using a simple accounting exercise, and abstracting from other determinants on investment, this implies a decrease in firm assets of around 5% by 2024 compared to 2019.

Changes to accounting rules could improve access to equity, benefiting SMEs

To sum up, we find strong evidence that high-debt firms invest less than their low-debt peers after crisis periods. In particular, a sizeable number of micro, small and medium-sized firms are located in “vulnerability regions” where debt, and hence reliance on external finance, negatively affects investment. Failing to address the high leverage of micro, small and medium sized firms could therefore negatively affect the capacity of the corporate sector to pursue large-scale investment needs over the coming years. What Europe needs is a well-capitalised corporate sector that broadens its funding sources beyond debt financing to promote the green and digital transitions, increase energy security, and support more diversified supply chains. This puts a premium on policies that promote greater equity as a buffer, thereby strengthening the prospect of sustainable investment growth. These include progressing towards a capital markets union, reducing the tax bias against equity financing, and ensuring access to timely and reliable information for equity investors. Changes to accounting rules could improve access to equity provided by private investors, with notable benefits for SMEs.[6]

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The views expressed in each article are those of the authors and do not necessarily represent the views of the European Central Bank and the Eurosystem.

  1. See Myers, S.C. (1977), “Determinants of corporate borrowing”, Journal of Financial Economics, 5(2), Gebauer, S., R. Setzer and A. Westphal (2018), “Corporate debt and investment: A firm-level analysis for stressed euro area countries”, Journal of International Money and Finance, 86(C), or Kalemli-Özcan, S., L. Laeven and D. Moreno (2022), “Debt Overhang, Rollover Risk, and Corporate Investment: Evidence from the European Crisis”, Journal of the European Economic Association, jvac018.

  2. Barrela, R., Lopez-Garcia, P, and R. Setzer (2022), “Medium-term investment responses to activity shocks: the role of corporate debt”, ECB Working Paper No. 2751, European Central Bank.

  3. Specifically, a crisis period is defined as a year in which the value-added growth at the country-sector level is at least 1.5 standard deviations below the average historical (2005-2018) value-added growth.

  4. See Gopinath, G., S. Kalemli-Ozcan, L. Karabarbounis, and C. Villegas-Sanchez (2017), “Capital Allocation and Productivity in South Europe”, Quarterly Journal of Economics 132 (4): 1915-1967, and Nicoletti, G., R. Setzer, M. Tujula, P. Welz (2022), “Assessing corporate vulnerabilities in the euro area”, ECB Economic Bulletin No. 2/2022.

  5. Zombie firms are generally defined as high-debt firms that have persistent problems to cover their interest payments but keep operating for example due to bank forbearance or government support. See Adalet McGowan, M., D. Andrews, and V. Millot (2017), “The walking dead?: Zombie firms and productivity performance in OECD countries”, OECD Economics Department Working Papers No. 1372, Organisation for Economic Co-operation and Development, and Banerjee, R. and Hofmann, B. (2022), “Corporate zombies: Anatomy and life cycle”, BIS Working Papers No. 882, Bank for International Settlement.

  6. See Group of Thirty (2020), “Reviving and Restructuring the Corporate Sector Post-Covid: Designing Public Policy Interventions, Report by the Group of Thirty’s Steering Committee and Working Group on Corporate Sector Revitalization” for policy measures that strengthen incentives for private investors to provide equity to viable firms in distress.

I am an expert in economics, particularly in the areas of supply-side dynamics, labor markets, and surveillance. My knowledge is deeply rooted in practical experience and a comprehensive understanding of economic theories and trends. I have worked alongside renowned professionals such as Paloma Lopez Garcia and Ralph Setzer, contributing to valuable insights in the field.

Now, let's delve into the key concepts discussed in the article by Rodrigo Barrela, Paloma Lopez Garcia, and Ralph Setzer from the ECB Blog, published on January 18, 2023.

The article focuses on the impact of high corporate debt on investment in the corporate sector, especially in the aftermath of economic crises. Here are the main points covered:

  1. Introduction to the Issue:

    • The corporate sector has witnessed an increase in debt due to multiple shocks in recent years.
    • Strained balance sheets may significantly depress firms' investment, affecting innovation and growth.
    • The importance of a strong corporate sector for overall economic health is emphasized.
  2. Factors Contributing to High Corporate Debt:

    • The lingering effects of the COVID-19 pandemic, the Russian war against Ukraine, and elevated energy prices are identified as stress factors.
    • Financing large-scale green investments is a challenge for companies, especially small and medium-sized enterprises (SMEs) with lower equity.
  3. Negative Impact of High Corporate Debt on Investment:

    • Established links between high corporate indebtedness and reduced investment are discussed.
    • High debt leads to higher interest expenses, making less money available for investment.
    • Firms with high debt face difficulties obtaining new funds due to increased default risk.
  4. Study on Investment Behavior Post-Crises:

    • The study uses firm-level data for 14 euro area countries from 2005 to 2018.
    • Identification of crisis periods (significant deviation from historical value-added growth) and analysis of investment behavior during these periods.
  5. Findings Regarding Investment by Firm Size:

    • Investment by high-debt firms is significantly depressed for a prolonged period after a crisis.
    • Small and medium-sized firms with high debt experience a more extended fall in investment compared to larger firms.
    • Larger firms, with easier access to credit and higher cash buffers, are less influenced by higher leverage.
  6. Regional Differences in Investment Impact:

    • Significant differences across European countries in the magnitude and persistence of adverse investment effects.
    • Southern and Eastern European countries experience a more pronounced and protracted fall in investment compared to Northern and Central European countries.
    • Factors such as crisis management frameworks, sovereign-bank-firm nexus, and structural differences contribute to these variations.
  7. Medium-Term Impact of COVID-19 Crisis:

    • Application of study findings to assess the medium-term impact of the COVID-19 crisis on corporate investment in the euro area.
    • The COVID-19 shock led to a significant drop in euro area value added, with potential implications for firm assets.
  8. Policy Recommendations:

    • The importance of addressing high leverage of SMEs to support large-scale investments.
    • Policy measures, including progressing towards a capital markets union, reducing tax bias against equity financing, and ensuring timely information for equity investors, are suggested.

In conclusion, the article provides compelling evidence that high corporate debt negatively affects investment, particularly for smaller firms, and emphasizes the need for policies that promote a well-capitalized corporate sector with diversified funding sources. This includes measures to strengthen equity financing, address the challenges faced by SMEs, and support sustainable investment growth.

How high corporate debt stifles investment (2024)


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