Most of the focus on excessive leverage has been on China – and on overall debt levels. However, in June David Lipton, First Deputy Managing Director, IMF, speaking at China Economic Society Event, drew attention to the real problem: Chinese corporate debt.
“Corporate debt remains a serious — and growing — problem [in China] that must be addressed,” he said, pointing out that, “Overall, total debt is equal to about 225 percent of GDP. Of that, government debt represents about 40 percent of GDP. Meanwhile, households are about 40 percent. Both are not particularly high by international standards. Corporate debt is a different matter: about 145 percent of GDP, which is very high by any measure.”
In October 2016, the IMF made the point more forcefully still in a working paper entitled “Resolving China’s Corporate Debt Problem”. The paper estimated potential debt at risk to be about 15.5 percent of the total corporate loan portfolio as of end-2015. Default on this would trigger losses of about 7 percent of GDP. And even a well-planned process of closing and consolidating unproductive firms could cost up to 0.6 percent of GDP in its first year.
Other emerging markets corporate have come under scrutiny too, from Mexico to Turkey, Russia to Indonesia. But should US and European treasurers and CFOs actually be the most concerned? Are they taking credit availability and the ability to service their debts for granted?
The cash pile mirage
On the face of it, that seems a strange question. After all, the big corporate story in developed markets has been cash piles not debt levels, but that focus is extremely misleading. The vast majority of that cash hoard is held by just a few huge companies in a small group of sectors. According to a mid-year report by S&P Global Ratings, if you remove the top 25 cash holders, cash on hand at US companies is declining while debt rises. The bottom 99% of corporate borrowers have $900 billion in cash but $6 trillion in debt. “This resulted in a cash-to-debt ratio of 12%—the lowest recorded over the past decade, including the years preceding the Great Recession,” says S&P. Corporate leverage too is at a 12-year high.
The stress is showing up in downgrades and defaults. Almost 6 percent of U.S. corporate bonds were downgraded just in the third quarter of this year, the largest proportion since 2009, according to Fitch Ratings in a report issued in November. Globally, corporate defaults are also the highest they have been since 2009.
If profits were still rising, the leverage issue would be less pressing, but corporate profits have been declining for almost a year now even in the absence of wage pressures. If the huge amounts of debt companies had taken on had been invested in future profitability through R&D or investment in new products or capex, again the issue might be less pressing, but most of the cheap borrowing was spent on M&A (a notoriously poor way to build long-term profit growth) and to fund share buybacks and dividend payments to support share prices in the face of lacklustre profits.
The poster child for this strategy has been Macy’s which has leveraged up to spend $5.2 billion buying its own stock expensively while incurring ratings downgrades and a profits slump.
So what happens when rates rise?
The big issue for companies and for treasurers trying to model cashflows and optimise balance sheets, is how rising interest rates will affect them given these high levels of debt and low levels of profit growth.
Treasurers and CFOs should be modelling worst-case scenarios now, to see whether current debt loads are sustainable. Non-core businesses need to be sold off to reduce leverage while other forms are still willing to make foolish acquisitions. Should short-term debt should be extended as soon as possible? Should all rollovers should be brought forward?
And balance sheet optimization needs to become a reality rather than just a mantra, because US corporates have a serious problem with return on capital. Citigroup’s Financial Strategy and Solutions Group recently compared returns on invested capital with the weighted-average cost of funding for companies in the MSCI World Index going back to 2010. They found that at a third of all companies, returns on capital were below the cost of capital, despite an extended period of ultra-low borrowing costs.
The worst-case scenario is not rising rates, though they pose a significant threat. It is a sudden tightening of credit conditions in which bond investors and banks withdrew from the credit markets as their assessment of risk changed. The threat is greatest for lesser-rated companies who have benefited most from investors’ hunt for yield and for all companies with heavy redemption schedules. Tweaking treasury structures and looking at the blockchain may come to seem like luxuries.
In that speech on China, David Lipton was clear that corporate debt – wherever it is– was a pressing issue of our times. As he said in Shanghai, “Company debt problems today can become systemic debt problems tomorrow. Systemic debt problems can lead to much lower economic growth, or a banking crisis. Or both.”