After a long phase with only slight signs of systemic risk on the international financial markets, the various risk indicators have increased noticeably for the first time in recent months as a result of the recent market turmoil. Historically, the indicators are still low, but now a development that has largely remained unnoticed is coming to the fore – a remarkable divergence between real economic and financial developments on the one hand, and within the financial sector on the other. Three factors are particularly noteworthy.
Profit and stock market prices
If the development of nominal gross domestic product (GDP) is understood as a rough indicator of the overall economic earnings trend, it is striking that in the industrialized countries the valuation on the stock exchanges has increased significantly faster than GDP in recent years. Whether the profit expectations contained in the share prices can be met will in turn depend crucially on the investment activity.
Investment and debt
However, a further divergence can be observed here. Investment growth has slowed noticeably in industrialized countries, with expected negative impacts on the speed of technology transfer and growth potential. At the same time, however, corporate debt and corporate investment are drifting apart. In almost all OECD countries, the dynamics of corporate debt to GDP before the financial crisis was marked by a significant increase in debt levels. After the crisis, there was initially a limited downward movement in debt. However, in recent years, debt to non-financial corporations relative to GDP has risen again in many OECD countries. However, a higher debt ratio increases the vulnerability of balance sheets to external shocks such as interest rate hikes.
Debt and credit quality
Finally, if you turn to corporate debt yourself, the statistics initially show a trend away from bank loans and towards bonds. According to calculations by the OECD, the share of bank loans in the total debt financing of companies in industrialized countries has decreased by around 5 percentage points since 2008. This deepening of the bond markets can have a positive impact on companies by diversifying funding sources and extending maturities.
It would therefore not be a problem in itself, but the statistics also show that the expansion of bond issues was bought with a steady decline in credit quality. At the same time, however, investors’ willingness to take risks increased due to the long period of low interest rates, which is documented in the narrowing of the risk spreads. Only the increasing risk appetite led to a massive increase in the issuance of high-risk bonds.
Susceptibility to shocks increases
This increases the vulnerability of the debt capital markets and exposes bondholders to considerable risks. In summary, these developments give a picture of the economies of the industrialized countries, which shows an increased susceptibility to shocks, such as changes in growth prospects or the effects of a rise in interest rates.
Of course, debt financing does not necessarily lead to financial difficulties. However, it is advisable to take a close look at high and growing debt while changing the composition of the financial portfolios, especially in times of exceptionally low but likely rising interest rates. In the years since the financial crisis, risks have shifted from the banking system to other financial institutions and credit intermediaries. However, regulation after the financial crisis focused mainly on the banks. Therefore, vigilance is advised as there is insufficient information on the risks posed by non-bank financial intermediaries.
Finally, the efficiency of capital allocation must ensure that corporate debt remains sustainable and does not affect growth in the medium term. However, the weakness in investment that has been observed since the crisis raises concerns that the increased funds raised will not be used to improve long-term production capacities.
Causes of growing divergence
This drifting apart of corporate debt and corporate investment can be seen both in the euro area and in the United States. The phenomenon can be interpreted in different ways. On the one hand, rising corporate debt correlates with a historically high volume of share buybacks. This could indicate that companies are borrowing to return funds to shareholders rather than to finance investments. An alternative explanation would be that the simultaneous increase in share buybacks and corporate debt stems from a more pessimistic view of future demand and economic growth that is causing companies to postpone capital spending. Thirdly, a planned change in the financing structure is also possible, towards stronger external financing due to the difference between equity and external capital costs.
Of particular concern with this development is that companies that are overly indebted generally lose competitiveness. A high level of debt and a bias in favor of debt financing creates a preference for safer investment projects even with healthy companies, with a high component of tangible assets, and stable and predictable profit prospects, which in turn could explain the currently low productivity growth.
Position of the banking association
The further development of the debt capital markets improves access to finance for companies by diversifying sources of finance. This is particularly useful when bank intermediation weakens, as was the case after the onset of the financial crisis.
However, the increasing importance of debt financing via the capital market means that the risks are increasingly shifting from bank intermediaries to non-bank financial companies.
The buffer function provided by banks in the past is becoming weaker. This increases the systemic risk.
While current levels of debt may not pose an immediate threat to corporate solvency, they will reduce their ability to withstand fluctuations in demand and increase their vulnerability to funding shocks. This applies in particular to tightening monetary policy or increasing refinancing risks.
The global evolution of corporate debt must be carefully monitored, as excessive debt can create a vulnerable environment for severe recessions and financial crises.