With global economic growth almost grinding to a standstill at the end of 2020, there is a global supply chains risk of widespread insolvency domino effect. This Covid-19-triggered event would impact virtually all sectors, geographies and business models.
Covid-sensitive sectors such as hospitality, non-food retail and transportation (especially air transport and automotive), are expected to bear the brunt of customer insolvencies. This could lead to global insolvencies increasing by +25% y/y in 2021, according to our latest Covid-19 report “Vaccine Economics”. But what exactly is the domino effect and why is it such a threat in terms of corporate insolvency risk?
In essence, the insolvency domino effect is a chain reaction which starts when an insolvent company is unable to meet its obligations to its trading partners. In its simplest form, this is when a company is unable to settle payments with customers and suppliers, leaving them with unpaid invoices.
Triggering an insolvency chain reaction
Maxime Lemerle, Head of Sector and Insolvency Research at Euler Hermes, explains that such insolvencies undermine wider supply chain liquidity making the domino effect more likely. He says: “This inability to meet obligations can trigger a knock-on effect through trading networks, along the linkages between companies, sectors and countries, ultimately leading to other payment defaults and insolvencies.”So, with the resurgence of Covid-19 infections and imposition of fresh lockdowns, why haven’t we already seen the corporate insolvency domino effect in action? The simple answer, according to Marine Bochot, Head of Group Credit Underwriting at Euler Hermes, is that “unlike any previous crisis, the massive amount of state aid pumped into the markets by developed and emerging economies prevents liquidity crisis of businesses.”
Instead of witnessing a wave of insolvencies, state intervention has absorbed the Covid-19 shock, enabling many companies to avoid insolvency – at least for the time being.
Maxime says: “It is clear that the massive state assistance from governments has ‘frozen’ the situation of many companies and led to an unprecedented and artificial fall in business insolvencies worldwide during 2020. The phasing out of state supports still depends on pandemic uncertainty. Yet, albeit gradually and orderly, it will trigger a return to a normalised number of insolvencies with two kinds of insolvencies: those of companies that were no longer viable before the crisis but were kept afloat by emergency measures, and those of companies weakened by the crisis, due to over-indebtedness or under-capitalisation.”
Under normal conditions, a wide range of factors influence the severity, penetration and level of supply chain risk achieved by the insolvency domino effect. For example, while there is market liquidity and access to credit, the impact can be less pronounced.
It also depends on the extent to which companies and sectors rely heavily on any given organisation before it goes bust. If reliance on a business is high – the famous sales or supply concentration factor – then the insolvency risk will be high too and the effect can be dramatic.
Surprise is another key factor. If you are able to predict that a player will encounter difficulties you can mitigate or even prevent losses before they happen. On the other hand, if events take place at speed or on a very large scale with long supply chain or long payment terms across the chain, the corporate insolvency domino effect is potentially heightened.