Financial Stability Paper No. 48
By Mai Daher and Christiane Kneer
Many UK firms weathered the Covid-19 shock by taking on debt. Small and medium-sized enterprises (SMEs) in particular borrowed at an unprecedented rate and their debt increased by around a quarter since 2019. But debt that allowed SMEs to survive the pandemic could now hamper the recovery as indebted firms may struggle to invest and grow. Debt on SMEs’ balance sheets could also make firms more vulnerable to future shocks and amplify downturns if indebted firms reduce investment more following shocks. To understand how investment might evolve in the future, this paper examines the effect of leverage on SME investment during and after the global financial crisis (GFC) and discusses regulatory and other changes since the GFC that could have altered debt-investment sensitivities. Using firm balance sheet data, we show that SMEs with more leverage at the onset of the GFC invested less, both during the crisis and the subsequent recovery period. The impact of leverage on investment was persistent and increased over time up until 2014. We find that the negative relationship between leverage and investment was driven by capital-intensive firms and by firms with short-term liabilities. Our evidence also suggests that credit supply constrained investment by leveraged firms after the GFC.