Benoit Mario Papillon, Ph.D.
Department of Finance and Economics
School of Management, UQTR

The OSB reports a business insolvency rate for 2022 of 0.8 companies per thousand existing businesses. This is higher than in 2021, when the rate was 0.6 per thousand. An increase of 0.2 compared with a value of 0.6 represents an increase of 33.3%, which is significant. Moreover, this is the only significant increase in the annual business insolvency rate in Canada in 25 years. The milestone for this 25-year period is a sharp drop in Canada's business insolvency rate.

From a rate of 13.9 companies per thousand in 1997, it fell below the 1 per thousand mark twenty years later or, more precisely, 0.9 per thousand in 2017. That's a drop of over 90%. This is a major trend, because apart from a slight bump from 5.7 per thousand to 5.8 per thousand between 2000 and 2001, this sharp drop has been gradual and continuous. And this is despite a rise in interest rates around 2000 and 2008.

To explain this trend, we must take into account the economic climate, particularly in recent years. The steep decline over the long term means that other variables also need to be taken into account.

Recent Trends, COVID Policies and the Cost of Credit

Numerous empirical studies, in Canada and elsewhere, combining several decades of observations, have demonstrated that a rise in the cost of credit has an upward impact on the rate of business insolvency. The significant rise in the business insolvency rate since 2021 is attributable, at least in part, to the rising cost of credit.

The effect of the rising cost of credit is all the more significant given that during the decade of the 2010s, the prime rate for bank financing remained around 3%, which is a historically low rate, even going back to the 1940s. Many companies that started up in this decade have reached the break-even point in business models that assume a very low cost of capital. With prime rates rapidly rising from 3% to 6% and beyond, many are becoming insolvent. Both 2022 and 2023 therefore combine the cumulative effect of these business models applied over several years. The COVID phenomenon and certain public policies designed to reduce its harmful consequences have amplified this cumulative effect.

Companies involved in the supply of medical goods and services needed to contain COVID have enjoyed good profitability. For other companies, however, the pandemic resulted in lost earnings and increased costs, pushing a number of them into a state of insolvency, even though their business model had been generating a good level of profitability prior to the crisis. Public policies of a general scope, such as the Canadian Emergency Business Account (CEBA), or of a sectoral scope, such as air transport, have limited the impact of the crisis. Some of the companies that benefited from these policies would have become insolvent had it not been for the health crisis. The withdrawal of these policies has an effect on the insolvency rate, in addition to the cumulative effect of a decade of exceptionally low prime rates. These considerations do not call into question the validity of these policies. The purpose is simply to provide a more comprehensive interpretation of trends in the business insolvency rate.

During the pandemic, several governments took exceptional measures affecting the lives of businesses and citizens, such as the partial or total closure of certain companies and business centres. On more than one occasion, the pandemic has been compared to the situation of a country at war, when governments must implement economic mechanisms typical of highly centralized economies: quota-based allocation of basic commodities such as coal and steel to priority sectors, ration coupons to manage shortages of consumer goods, etc. In Canada during World War II (1939-45), this centralization was achieved under the leadership of Minister C.D. Howe. In many ways, this brings us back to some of the issues raised by the sharp drop in Canada's business insolvency rate over the last few decades.

Business insolvency: The tip of the iceberg or an indicator of fundamentals?

The business insolvency rate is a product of two components. The first component is the proportion of companies in financial difficulty, to the point of insolvency, in the total population of companies. The second component is the proportion of companies entering into insolvency proceedings among the subset of companies in financial difficulty to the point of insolvency.

The second component measures the scope of insolvency laws. Ultimately, this component may be equal to 1 if all companies in financial difficulty to the point of insolvency enter into insolvency proceedings. If the expected benefits of insolvency proceedings are low in relation to the costs and time involved, the value will be less than 1. This cost-benefit calculation depends on the level of deterioration in the company's balance sheet. It is also subject to legal provisions concerning guarantees and securities for creditors.

The first component of the insolvency rate (the proportion of companies in difficulty in the total business population) is dependent on structural variables. If a country's economy is largely made up of sectors with high barriers to entry, such as the steel industry, there will be little competition. Rivalry between existing companies may be strong, but the arrival of new competitors threatening their profitability is unlikely. The first component will also depend on institutional variables. If banks have very close links with companies, or as is the case in Japan, are connected to large groups, corrective measures will be taken quickly to avoid difficulties, or to conceal them. Some thirty years ago, the first research on zombie firms drew on the latter possibility to analyze how the underlying practices can reduce competition, innovation and productivity growth.

These considerations on the rate of business insolvency and the effect of economic conditions lend credence to the thesis that the phenomenon of business insolvency is analogous to the tip of an iceberg, reflecting and combining the effects of a mass of factors acting below the surface. But this thesis, as inclusive as it is, does not recognize all the information that the phenomenon of business insolvency can carry.

The first component of the business insolvency rate depends not only on structural and institutional variables, but also on public policies, including competition policy and business subsidy programs. Recent research suggests three things: 1) competition in the Canadian economy is less intense than it was a few decades ago; 2) business subsidies represent increasingly large sums of money; and 3) the rate of new business start-ups and the underlying entrepreneurial spirit have declined.

Prior to the writings on zombie firms, research on centralized economies, particularly in Eastern Europe, focused on a very similar phenomenon, studying the soft budget constraint of the "companies" or production units in these economies. The managers of these production units, which were systematically sheltered from competition, directed their energy towards political considerations in order to obtain the resources to enable them to operate. This diverted their focus from researching ways of better meeting the needs of the population they served, and at lower cost, either directly or indirectly through the supply of semi-processed goods and services to other companies. One of the challenges of decentralization for these economies has been to set up an insolvency regime. Is it possible that the growing importance of business subsidies in the Canadian economy, and the reduced competition, are both diverting entrepreneurial energy in certain sectors and neutralizing the selective effect of an insolvency regime?

Current inflationary pressures in the Canadian economy are generally interpreted as a cyclical phenomenon. There is another possible interpretation. The notion of soft budget constraint is often associated with the Hungarian economist Janos Kornai, who focused his research on the shortcomings of centralized economies. Among Kornai's other notable works, is a treatise on the economics of shortages. These two concepts - soft budget constraints and shortages - suggest other possible causes of rising prices.

With the 2010s culminating in very aggressive government policies regarding COVID, and we can even go back to the aggressive government policies surrounding the 2008 financial crisis, is there any reason to consider the hypothesis that the Canadian economy has undergone fundamental changes making it more centralized? The marked long-term drop in the business insolvency rate suggests that this is a possibility. Should a minister be appointed for reconstruction and free enterprise, as C.D. Howe was in 1945?