Insights

May 10, 2021

Competition
State Aid
Do desperate times call for desperate measures? State intervention during the Coronavirus pandemic (Part II).

Besides the tremendous humanitarian consequences, the Coronavirus pandemic also has a severe impact on the economic situation of many companies in the short and medium term. The European Commission has therefore enacted state aid measures under Articles 107(2)b, 107(3)b and 107(3)c TFEU and under the State Aid Temporary Framework,1 which allows Member States to grant state aid to affected companies that are otherwise economically healthy such that they may sustain operations. These measures are aimed at preserving efficient operations and consequently competition in affected markets in the short and medium term corresponding to the situation that would generally be observed in absence of the pandemic, i.e. the so-called “counterfactual scenario”. From an economic perspective, these state aid measures are only appropriate if companies are facing financial bottlenecks or insolvency because of Coronavirus-related demand or supply shocks but not because of a self-inflicted economically desolate situation. Unless the consequences of Coronavirus related measures on different areas are carefully thought through, they will potentially be ineffective and further distort competitive markets.

State aid – the example of Galeria Karstadt Kaufhof

One prominent example where the German government has granted state aid during the Coronavirus pandemic is the case of GKK.2 As GKK could no longer afford its monthly fixed costs, the German government announced at the end of January 2021 that it would support the largest German department store chain with a loan of 460 million EUR to enable GKK to overcome the increasingly difficult economic situation caused by the second lockdown due to the Coronavirus outbreak. The Committee of the State Economic Stabilisation Fund (“ESF”) which was convened by the German government in March 2020 to stabilise the economy in response to the Coronavirus pandemic by supporting financially distressed undertakings whose demise would have a noticeable impact on the German labour market3, subsequently approved a subordinated loan4 for GKK after the German Federal Ministry of Economics and the German Federal Ministry of Finance had reached an agreement5.

In particular, the government publicly justified its decision by arguing that it safeguards countless jobs. In addition, the German Retail Association (Handelsverband Deutschland – “HDE”) has also tried to influence the government’s decision by submitting a formal letter to the German Minister of Finance Olaf Scholz and describing the second largest department store chain as “the most important anchor and visitor magnet and being system-relevant for the future of German city centres” as well as “essential for survival” for “the entire inner-city life” (own translation into English).Besides, GKK affirmed that the state aid does not pose a risk to taxpayers because it will repay the entire loan including interests.7

It is notable in this context that GKK was already in serious economic strain before the Coronavirus pandemic started to have an impact on the retail market in March 2020. Only one month after this date (in April 2020), GKK entered an insolvency proceeding as part of the so-called protective shield proceedings. These protective shield proceedings are a subset of preliminary insolvency proceedings under self-administration. Under the supervision of the insolvency court, it allows the management to maintain control over the company.8 As a result of the insolvency proceeding, GKK closed about 40 department stores and negotiated reduced rents for further stores. The insolvency proceeding could be completed in October 2020 after GKK’s creditors waived their claims in the total amount of 2.2 billion EUR. However, the recovery was only short-lived. When the second lockdown started in December 2020, GKK was soon back in the same position as in April 2020 so that staid aid was granted at the end of January 2021 after negotiations between GKK and the government.9

Commentary

In the absence of external shocks, a competitive market outcome ensures a pareto-efficient allocation of resources - meaning that more efficient market participants will gain market shares to the detriment of less efficient participants. Consequently, insolvency and bankruptcy of less efficient companies can be beneficial for costumers and the economy as a whole, thereby increasing overall welfare. Against this background, state aid should only be granted with great caution. It bears the risk of creating a competitive imbalance and thus undermining the efficient functioning of competitive forces if any one of the following four aspects holds:

  1. State aid is granted to companies that are less efficient market participants and would face the same financial and/or economic difficulties in the absence of the Coronavirus pandemic.
  2. State aid creates a competitive disadvantage for efficient market participants acting in the same market which do not receive state aid. Less efficient firms that receive state aid will have more financial resources for investments and thus become more competitive.
  3. The amount of state aid granted is too lavish and justified primarily by safeguarding jobs. This could cause companies to become less efficient because they expect to receive state aid again in the future if they fail.
  4. State aid is granted to companies that are in a transition phase because of structural changes within the sector or due to the implementation of new product standards in their industry. In such transition phases, the market undergoes substantial changes and as such, it is common for the least efficient participants to exit the market.

In the occurrence of external shocks such as the current Coronavirus pandemic, it is challenging for governments to identify the reasons for the precarious situation of a company applying for state aid. Provided that a company was already in an economically precarious situation before the shock, it is more likely that it would face the same economic restrictions in a counterfactual scenario without said shock and would have to exit the market at least in the medium to long term. Consequently, state aid bears the risk of undermining the efficient functioning of competition if a temporary and external decline in demand or supply merely triggers an acceleration of a company’s economic decline and said company cannot be considered as relevant to the functioning of the economy as a whole.

To ensure that the government’s financial resources will not be fundamentally misallocated, it is crucial that the above-mentioned aspects (i) – (iv) are considered. Before comparing the counterfactual situation, in which no aid is granted to the company, with the respective factual scenario in which aid is granted in a so-called impact analysis, one should first perform a so-called root-cause analysis that examines the reasons why the company is facing economic restrictions, i.e., is the company’s dire situation purely the result of the external shock or rather caused by competitive forces. An adequate analysis must examine whether the business model of the company concerned is also viable and competitive in the future or whether the granted aid will at least be used to make the company sufficiently competitive. The government must ensure a future repayment of the granted loan plus interests, rather than running the risk of delaying an eventual insolvency and spending tax income in the process.

Therefore, the granted state aid for GKK must be assessed against the above-mentioned background: In general, state aid under the WSF is always linked to the protection of jobs. The HDE emphasized that in the event of GKK’s insolvency, not only would 17,000 employees lose their jobs, also those jobs of countless employees of GKK’s respective suppliers would be in jeopardy. There is no doubt that the economic consequences of an insolvency would be noticeably felt, at least in the short to medium term.

Since GKK completed its insolvency proceeding initiated immediately after the start of the first lockdown only in October 2020, it is not straightforward that GKK was facing financial restrictions induced solely by the Coronavirus pandemic. A broader assessment, i.e., including a well-founded root cause analysis would have been required. If such an analysis was carried out, the results should have been communicated publicly. Almost every economic sector and numerous small and medium-sized enterprises (“SME”) are affected by the pandemic and facing financial restrictions or even insolvency proceedings, although they would probably be in a healthy economic position had it not been for the pandemic. Since these companies do not receive the same financial support as GKK, the government must at least provide valid and comprehensive reasons for its decision.

Indeed, there are reasons suggesting the government took the wrong decision in the case of GKK. Prior to the Coronavirus pandemic, the retail industry apparently was in a transition phase, shifting more and more to the online sector. The fact that GKK generates less than 5% of its sales online10 suggests that GKK may have missed this crucial shift in the market. In addition, GKK is facing excessive rent payments for numerous stores in city centres, which are only affordable if demand is sufficiently large and stable. The ongoing decline in sales due to stronger competitive pressure from the online trade, entry of new competitors and the fact that GKK already faced financial troubles before the Coronavirus pandemic give the impression that GKK’s business model is – at least becoming - obsolete and will not be viable in the long term. The chairman of Germany’s Monopolies Commission Jürgen Kühling has also raised his concerns about the planned state aid for GKK before it was approved. Indeed, he also emphasised that state aid for individual companies during the Coronavirus pandemic is in general appropriate and desirable, as an imposed lockdown practically brings businesses to a screeching halt. However, in the case of GKK he pointed out that given the sluggish digitalisation and the fact that GKK was granted a subordinated loan recently, the governments’ decision seems poorly thought out. In the event of a future insolvency there should be almost no chance of a repayment.11

A further and crucial aspect that must be considered in the government’s decision making is how a company will use its granted state aid. This is of specific significance for GKK. If GKK uses the granted funds for the modernization of its business model to make it more competitive by expanding its online commerce, the granted state aid might be appropriate. If it is exclusively used to cover fixed costs and order new inventory, the tax money could have been invested more efficiently in other companies that are facing financial restrictions solely due to the Coronavirus pandemic but cultivated forward-looking, sustainable and competitive business models. In the case of GKK, it is still unclear whether the state aid granted under the pretext of remedying the effects of the Coronavirus pandemic will enable GKK to avoid insolvency or whether this insolvency is inevitable and simply postponed to the future through the use of tax income. In this context, it must be noted as well that the German Association of SME’s is warning against growing resentment among smaller competitors. Even if the state aid is justified, other market participants should not get the impression that large companies such as GKK (or TUI and Lufthansa) receive prompt and generous aid while SME’s are neglected.

Conclusion

An efficiently allocation of state aid to limit the negative effects of external shocks on competitive markets should consider the following issues: First, a distinction should be made between (i) companies applying for state aid, which would be in a healthy economic situation in a respective counterfactual scenario and (ii) those companies which would also face an economically precarious situation in absence the shock. Companies whose financial restrictions were primarily triggered by the shock will probably still face a sufficiently high demand in the future to continue operations. Such companies are likely to repay their loan including interest, such that state aid measures are legitimate to sustain efficient competition in the medium to long term. State aid granted to companies for which an external shock accelerated a precarious situation, as by all indications in the case of GKK, and for which it is uncertain whether their business model will be sustainable in the future, is likely to miss its objective. Therefore, it is important that the government further ensures that granted aid will be used to restructure the business model of such companies such that they can become more competitive and sustainable. Otherwise, GKK is more than likely to again face problems post-corona and the granted aid could turn out to be a waste of taxpayers’ money.

Since the pandemic has interfered abruptly with virtually all areas of life with an unexpected force, it is clear that such circumstances require fast decision making by governments. It is straightforward that not all aspects can be considered equally: For example, business performance indicators can be evaluated much easier and faster than the competitive structure of a market under consideration to decide if the business model of a company is (becoming) obsolete or still sustainable in the future. Accordingly, the boundary between company’s failures caused by external factors beyond the company’s control and failures caused by a lack of competitiveness could be quite narrow.

Second, state aid measures need to be scrutinised more closely, especially if (i) state aid is granted to companies that are established in sectors which are undergoing essential structural changes and/or changes in the demand behaviour (e.g. due to digitalisation or climate change related issues) and (ii) where entry is likely (because of low sunk costs) and (iii) a sufficiently large demand in the counterfactual scenario is uncertain. If the state aid is then also justified primarily by saving countless jobs, the proportionality of the rescue should be questioned. In this case, the state funds would probably be better invested in promoting the growth process of other companies with a more competitive and sustainable business model in the respective sector to create and secure new and long-lasting jobs.

[1] See https://www.focus.de/finanzen/boerse/hoffnung-fuer-warenhauskette-insolvenzverfahren-bei-galeria-karstadt-kaufhof-aufgehoben_id_12489144.html [last accessed 07.05.2021].

[2] Two further prominent examples in which state aid was granted are the cases of Lufthansa and TUI.

[3] See https://www.bmwi.de/Redaktion/EN/corona-virus/economic-stabilisation-fund-esf.html [07.05.2021].

[4] A subordinated loan is subject to strict and extensive conditions, such as an appropriate interest payment. In the event of a borrower’s insolvency a subordinated loan is subordinated to other claims of other creditors.

[5] See https://www.wiwo.de/unternehmen/handel/wirtschaftsstabilisierungsfonds-staatliche-stuetze-fuer-galeria-karstadt-kaufhof-offenbar-beschlossen/26858386.html [last accessed 07.05.2021].

[6] See https://www.msn.com/de-de/finanzen/top-stories/handelsverband-fordert-staatshilfen-f%C3%BCr-galeria-karstadt-kaufhof-und-nennt-deren-kaufh%C3%A4user-systemrelevant/ar-BB1d8quE [last accessed 07.05.2021].

[7] See https://www.onvista.de/news/bund-stuetzt-galeria-karstadt-kaufhof-430295437 [last accessed 07.05.2021].

[8] See https://www.juraforum.de/lexikon/schutzschirmverfahren, [last accessed 07.05.2021].

[9] See https://www.wiwo.de/unternehmen/handel/wirtschaftsstabilisierungsfonds-staatliche-stuetze-fuer-galeria-karstadt-kaufhof-offenbar-beschlossen/26858386.html [last accessed 07.05.2021].

[10] See https://www.focus.de/finanzen/boerse/hoffnung-fuer-warenhauskette-insolvenzverfahren-bei-galeria-karstadt-kaufhof-aufgehoben_id_12489144.html [last accessed 07.05.2021].

[11] See https://www.sueddeutsche.de/wirtschaft/einzelhandel-essen-chef-der-monopolkommission-sieht-kredit-fuer-galeria-kritisch-dpa.urn-newsml-dpa-com-20090101-210129-99-216327 [last accessed 07.05.2021].

Any opinions expressed in this communication are personal and are not attributable to Competition Economists Group