Amid growing speculation that the end of the Bank of Japan's negative interest rate policy is imminent, interest is growing in the impact of Japan’s return to a world with interest rates applied to various sectors of the economy. One of the relevant issues is whether rising borrowing rates will make it difficult for companies to run their business operations. This article focuses on small and medium enterprises (SMEs), examining financial problems they would face in an environment where interest rates rise.
The first issue is the impact on SMEs as a whole. The question is how much of the interest-bearing debt on firms’ balance sheets would be likely to be affected by rising interest rates.
According to the Financial Statements Statistics of Corporations by Industry, borrowings from financial institutions and interest-bearing debt as a percentage of total assets have been declining since the latter half of the 1990s, standing at a level lower than in FY 2000 and 2006 when the zero interest rate policy was lifted. Although large-scale financial support to respond to the COVID-19 pandemic led to an increase in the percentage of borrowings from financial institutions at SMEs capitalized at 10 million to 100 million yen in FY2020, this increase was not large enough to reverse the overall downward trend.
Micro enterprises capitalized at less than 10 million yen are an exception. The percentage share for borrowings from financial institutions at these enterprises continued to rise in the 2010s and is now almost equal to the level for FY2000. However, these enterprises account for about 10% of total assets and loans covered by the statistics.
Given that profit levels have remained almost unchanged in the past, the impact of an increase in the burden of interest payments on SMEs as a whole is likely to be small if interest rates rise at the same pace as in past monetary policy tightening phases.
The second issue is the impact on SMEs that are heavily indebted. For companies that find it difficult to survive without support from financial institutions, the debt repayment burden increases significantly with an increase in borrowing rates, raising the probability of financial distress.
A working paper published by the Bank of Japan in March 2022 is useful to determining the extent to which SMEs are close to financial crisis. The working paper used multiple criteria to identify companies that survive with support from banks despite poor business performance and no prospect of recovery and determine these companies’ percentage share of the total number of SMEs. As far as indicated by the working paper, the share for SMEs likely to plunge into financial distress had not increased before the COVID-19 pandemic.
During the pandemic, companies that remined in poor financial condition used many special support measures, such as so-called “zero-zero loans,” or loans with no interest and no collateral. Any delay in the recovery of these firms will lead to an increase in the number of companies falling into financial distress. Interest rate hikes are expected to further boost the number of companies subjected to Bankruptcy Act or Civil Rehabilitation Act procedures, which turned upward in 2022.
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A notable change among heavily indebted SMEs is that debt restructuring methods for companies that plunge into financial distress and launch business turnaround efforts have become more diverse than during past monetary tightening phases.
There are two types of debt restructuring: legal bankruptcies, including civil rehabilitation, corporate reorganization, and liquidation procedures, in which all creditors participate with the courts involved, and out-of-court debt workouts, which are conducted mainly between financial institutions and companies without the involvement of the courts. Legal bankruptcies continue to be used in many cases, especially in liquidations. Among out-of-court debt workouts, those that are through formal government supported procedures have become widely used in the past 20 years.
In out-of-court workouts, companies can carry out debt restructuring while keeping their business partners unaware of the restructuring and continuing business operations and can save costs compared to legal bankruptcies. A mechanism is in place to support the formulation of out-of-court workout plans. In order to support SME business turnaround efforts including out-of-court workouts, the SME Revitalization Support Council (now called the SME Revitalization Council) was established in each prefecture in 2003 for experts such as lawyers and certified public accountants to support the formulation of revitalization plans. In recent years, the number of standard out-of-court workouts for which the SME Revitalization Council supports the formulation of plans has far exceeded the number of legal bankruptcies for rehabilitation.
Since out-of-court debt workouts are implemented privately by a limited scope of entities, their realities and impacts on relevant companies have not been empirically clarified. There are wide-ranging types of debt restructuring for out-of-court workouts, including from debt rescheduling for the temporary deferment of principal payments to debt forgiveness which cancels debt obligations. How debt rescheduling or forgiveness is chosen remains unknown, along with what types can improve post-restructuring business performance.
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In order to clarify these points, I collaborated with Professor Arito Ono at Chuo University, Project Professor Tomohito Honda at Kobe University, and Professor Yukihiro Yasuda at Hitotsubashi University to analyze the characteristics of about 10,000 companies subjected to formal out-of-court workouts and their post-restructuring performance by using anonymous and specific out-of-court workout data published by the prefectural SME Revitalization Councils. Our analysis findings are as follows:
First, drastic debt restructuring cases for formal out-of-court workouts were scarce (see table). The details of revitalization plans indicate that more than 90% of companies subjected to formal out-of-court workouts chose debt rescheduling, while only a little more than 10% adopted drastic measures such as debt forgiveness. Among measures for business owners accompanying out-of-court workouts, more than 60% adopted the reduction of executive compensation, while only about 20% took tougher measures (drastic management restructuring), such as retirement of CEOs, capital reduction, and private asset contribution.
Source: Uesugi et al. “Anatomy of Out-of-count Debt Workouts for SMEs” RIETI discussion paper (2023)
Second, many of the companies undergoing drastic debt restructuring are profitable but insolvent, matching theoretical predictions about debt overhang problems. In theory, it is forecast that the reduction or forgiveness of past debt would be desirable for both borrowers and lenders for companies that have a positive net present value but face difficulty raising funds due to insolvency.
When the main financial institution of a company undergoing a out-of-court workout is a Shinkin bank or a credit cooperative, the probability of drastic debt restructuring is low. This indicates that smaller financial institutions may have fewer financial resources to carry out the out-of-court workouts that are accompanied by drastic measures.
Furthermore, business performance changes at companies after their out-of-court workouts indicate that companies that underwent drastic debt restructuring improved both sales and profits beyond those subjected only to debt rescheduling. This shows that out-of-court workouts accompanied by drastic debt restructuring led to an improvement in business performance through the elimination of debt overhangs.
Our analysis failed to sufficiently control the endogeneity of estimates, leaving the possibility that financial institutions were allowing for drastic debt restructuring by selecting companies that are likely to improve their business performance. If our analysis implies a causal relationship, however, it may be desirable to take initiatives to increase drastic debt restructuring rather than rescheduling in out-of-court workouts. If financial institutions’ insufficient business resources and the attitude of their management teams are factors hindering drastic debt restructuring, it makes sense for the government to correct these insufficiencies.
A monetary policy shift amid the growing repayment of zero-zero loans provided during the COVID-19 pandemic will increase SMEs’ demand for debt restructuring. With regard to out-of-court workouts, it is necessary to examine the determinants and effects of such workouts and their relationship with legal bankruptcies and design a system that appropriately promotes business metabolism.
>> Original text in Japanese
* Translated by RIETI.
March 7, 2024 Nihon Keizai Shimbun
