Bouncebackability

• Despite the aggregate economy rising to 0.7 per cent above pre-pandemic levels in Q1 2022, business investment remains 9.1 per cent below.
• Corporate debt as a share of GDP rose only slightly during the pandemic and remains 15 percentage points below the financial crisis peak.
• Firms’ cash holdings have reached a record high – 28 per cent of GDP – showing that firms’ balance sheets are not a major barrier to investment.
• The pandemic led to large increases in the numbers of new firms: in Q1 2022, firm births were 20 per cent above levels prior to the pandemic.
• The share of workers mainly working from home has doubled compared to pre-pandemic to around 20 per cent by the end of 2021.
• Evidence of a large increase in productivity resulting from more working from home is limited: fewer than half of firms switching to working from home cite productivity improvements as a factor in the decision.

UK firms have, like every other part of the economy, faced a huge economic hit from the Covid-19 pandemic. At times, as many as four-in-ten firms faced revenue falls of over 20 per cent. So, a key question is: what is the current state of British firms as we emerge from the pandemic? This is important because experience of previous recessions tells us this matters a great deal for nature and strength of the recovery, and ultimately living standards.

Early narratives during the pandemic focussed on the likely long-term scarring from the sharpest recession in at least 100 years and the rise in ‘zombie’ unproductive firms. Here the worry was that the pandemic’s legacy would be one of debt-burdened firms unable to invest, hire or grow. Since then, narratives have shifted: there has been much hope pinned on the rise of working from home and firms’ adoption of new technologies – leading to a productivity boom and ramp up in investment. As usual, the real answer lies somewhere between these two extremes.

We expect recessions to be accompanied by a large fall in profits: the average post-war recession had a 3 per cent fall in the corporate profit share – the Covid-19 pandemic had just a 0.8 per cent fall. Recessions also usually come with firms facing rising debt and falling cash reserves. Again, the Covid-19 pandemic has been extraordinary, with non-financial corporations’ cash holdings climbing to their highest ever level (28 per cent of GDP up from 20 per cent at the start of 2020). The stock of corporate debt has risen, but at 75 per cent of GDP, it remains 15 percentage points below the financial crisis, when it peaked at 90 per cent.

The exceptional Government policy support for business is the key reason why the experience of pandemic has been so different. Public sector borrowing rose to a post-war high, almost £120 billion above the financial crisis peak (in real terms), to finance the most comprehensive economic support package ever enacted: £70 billion was spent on the Coronavirus Job Retention Scheme (CJRS) alone. These support measures, particularly the CJRS, were thought of as protecting households. And they were certainly successful in protecting incomes and maintaining employment. But the CJRS was also crucial in protecting firms, where around 80 per cent of larger businesses accessed the scheme at some point. During a recession, firms face falling demand, but costs do not fall at the same pace. This is particularly true for labour where, in recession, firms face the choice of continuing to pay workers who have less to do, or pay severance and other costs to reduce payroll numbers. The CJRS effectively nationalised this normal recession cost for businesses, and alongside other measures such as direct grants and tax reductions, has allowed firms to keep workers on but also remain on a reasonable financial footing. There were also clear macroeconomic advantages to this too with the average post-war recession being accompanied by a ‘scarring’ effect of GDP being 11 per cent lower than the pre-recession trend; the latest OBR forecast was for the scarring after this recession to be just 2 per cent by 2024.

Although the pandemic’s long-term effect on the economy will only become clear with time, there are some positive signs. Matching the relatively positive story on firm balance sheets, fewer firms failed during the pandemic and, perhaps more importantly, the number of new firms created increased. In the first quarter of 2022, firm creation was 20 per cent above its pre-pandemic level. And this is not just about catching up from a pre-pandemic slowdown; on the contrary, firm creation has been strong throughout the pandemic in a number of industries, particularly those related to the shift to online retail. During 2020 and 2021 total firm births in ‘growth’ industries were significantly higher: transport births were up by 59 per cent compared to three years before the pandemic, and up 45 per cent in wholesale and 34 per cent in retail. There are some areas where the increase in firm births does appear to be partly related to ‘catch-up’ – for example, accommodation and food services experienced a 4 per cent fall in firm creation during 2020 but bounced back to 14 per cent above pre-pandemic trends in 2021, and is up by 5 per cent in Q1 2022. New firms tend to have lower productivity than existing firms but those that survive have higher productivity growth rates and can help reallocate economic inputs across the economy. Both of these effects should support economic growth in the coming years, although the extent of the persistence in new firm creation remains to be seen.

Another key trend is the increase in working from home. This was already increasing pre-pandemic with the proportion of workers ‘usually’ working from home doubling between 2010 and the eve of the pandemic (5 to 10 per cent). But the pace of the increase exploded during the pandemic and some working from home has become embedded as the new normal for at least a fifth of the workforce. There are some reasons for thinking working from home could boost productivity. Those doing so during the pandemic were slightly more likely to report being more productive at home (29 per cent compared to 22 per cent who thought their productivity fell). And productivity gains are a factor driving adoption of working from home for 47 per cent of large firms. There are several mechanisms through which extra productivity could emerge, for example through the reduction in commuting times allowing longer working hours (i.e. increasing output per worker). The evidence is, however, mixed. And, to the extent there are productivity gains, these should be largely already be reflected in aggregate measures of productivity. Looking further ahead, the longer-term dynamics are unclear: there could be an improvement in job and skill matches as people move jobs over time but set against that is the difficulty in maintaining organisational culture, training and development which could materialise over time.

On balance, caution is needed in making strong assumptions about the longer-term effects of working from home. The benefits are more likely to go to higher-paid workers as those earning over £40,000 are almost five times as likely to be hybrid working as someone earning under £15,000 – 38 per cent and 8 per cent respectively. And some of the other areas we have seen shifts during the pandemic are now reversing. For example, during the pandemic, the share of retail spending online more than doubled from 15 per cent to over 35 per cent. But since then that share has fallen back and is now just 3 percentage points above the pre-pandemic trend.

The weakness in business investment has been the UK’s Achilles heel for many years. Investment flatlined following the 2016 EU referendum and the UK has a far lower capital stock per worker than some of its peers. Investment fell substantially during the pandemic, as is the norm during recessions. But the recovery has subsequently been weak: despite the economy exceeding its pre-pandemic size in 2022, business investment is still over 9 per cent below its peak. This is despite the Chancellor’s announced ‘super deduction’ policy – an aggressive tax reduction for investing firms. All this stands in contrast to the common claim that the pandemic would drive firms to wake up to digitisation and substantially expand investment in the long-term. Indeed, even those firms reporting increasing capital expenditure are around three times as likely to be doing the investment to cover deprecation as increasing efficiency (28 per cent and 9 per cent respectively). And there are some sectors which fair particularly badly – in education, for example, almost twice as many firms are planning to cut capital expenditure in May to July as increase it (13.1 per cent compared to 7.6 per cent).

But this weak recovery seems to be relatively unrelated to direct pandemic aftereffects. Normally recessions hamper firms’ ability to fund investments by reducing their own finances or harming access to external funding as banks retrench. But, this time is different: just 4 per cent of firms cited access to external financing as a barrier to more capital expenditure, and only 7 per cent internal funding. What is key is the level of uncertainty: 17 per cent of firms cite this as a barrier to investment. The pandemic caused unprecedented increases in uncertainty for businesses; that uncertainty is starting to recede with only 4 per cent of firms at the start of 2022 reporting that Covid-19 is the biggest source of uncertainty. However, uncertainty levels remain elevated – only around half of the pandemic rise in a measure of firms’ sales uncertainty has unwound. And the cost of living crisis is creating increased uncertainty for prices and increasing the risk of recession, with massive decreases in consumer confidence heralding a difficult time for businesses. This could be another headwind to the recovery in investment.

Overall, contrary to many predictions, firms have weathered the shock from the pandemic remarkably well, reflecting the scale and success of the Government’s policy response. What should be the focus of policy makers now? Rather than focusing on pandemic changes like the adoption of new technology and working from home, it is the UK’s history of weak business investment, which should be of particular concern. Importantly, this weakness in investment is not currently being driven by the typical aftereffects of a recession. Rather it reflects ongoing economic uncertainty, hampered by the cost of living crisis, which continues to be the biggest headwind firms are facing post-pandemic.