Mon, Mar 16, 2020 page15

• Credit crunch risks turning firms into zombie army

  • AFP, PARIS
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  A decade of easy money sloshing around the economy might come to haunt policymakers, as legions of firms hooked on cheap credit have no buffers to make it through the COVID-19 pandemic without serious damage, or outright failure.

  Amid signs that banks and investors have already retrenched their lending, central banks are trying to ensure that the flow of credit to businesses remains open.

  However, those loans, regardless of how soft they are, will still have to be paid back, and therein lies the rub, as many will not be able to generate enough revenue.

  The volume of corporate debt struck an all-time real-term high of US$13.5 trillion at the end of last year, the Organisation for Economic Co-operation and Development (OECD) said.

  Including bank borrowings, “the global [corporate] debt-to-GDP ratio ... is near a record high of 94 percent and is at, or near, all-time highs in many major economies,” Capital Economics said in a report.

  This has created a growing number of so-called zombie firms — companies that just manage to pay interest on their loans with ongoing credit deals, but have no prospect of settling upon the principal.

  CHEAP CREDIT

  A 2018 report by the Bank of International Settlements put zombie firms at between 6 and 12 percent of total companies, and said that ample cheap credit was partly to blame.

  Even if that number seems small, it can quickly turn into a major risk.

  Capital Economics Ltd said it had identified a “BBB bulge” in the US and eurozone corporate bond markets comprising just over half of all new investment-grade bonds over the past three years.

  “BBB” is the lowest investment-grade rating. When firms drop below this into “junk” territory, they face higher borrowing costs, as many investment funds are limited to buying only investment-grade bonds.

  A virus-induced recession or a surge in borrowing costs, or both, could trigger bond ratings agencies to downgrade many of these bonds into “junk” status.

  “The greater the virus-related disruption, the closer we will get to this tipping-point” with the virus acting as a “trigger,” Capital Economics warned.

  The OECD estimates that if a financial shock arrived comparable to 2008 then US$500 billion of corporate debt would migrate to “junk”-rated levels inside 12 months.

  Zombies and other struggling firms would then come under intense pressure to lower their debt through job cuts and salary freezes, as well as cutbacks on investment.

  ‘VICIOUS CIRCLE’

  However, “this then hits demand, which in turn prolongs downturns, which weigh on profitability, making further deleveraging more likely” in what becomes a vicious circle, Capital Economics said.

  Such an impact on the wider economy is what economists call second-round shocks, and can cause a longer and deeper crisis than the original upheaval.

  “We are at the eye of the storm,” said Vincent Marioni, European director for investments in Europe with Allianz Global Investors GmbH.

  “The important thing over the coming two months is to maintain the liquidity of firms and ensure that a liquidity crisis does not morph into an insolvency crisis,” said Florence Barjou, head of multi-asset investment with Lyxor Asset Management SAS.

  While central banks including the US Federal Reserve have lowered interest rates, they have also undertaken steps to ensure the credit taps remain open.

  The European Central Bank (ECB) unveiled a number of such so-called targeted measures after its meeting on Thursday.

  In particular, it lowered the rate on funds it makes available to banks to pass onto companies and in certain cases it will be paying banks to lend on the funds.

  The ECB, which supervises large banks in the eurozone, said that it would allow them to temporarily lower capital buffers and use additional types of assets.

  “Banks will see a weakening of their loan book quality as the effects of the virus will reduce global travel and factory output, and dampen domestic demand in Europe,” Moody’s Investors Service vice president and senior credit officer Bernhard Held said.

  NEGATIVE OUTLOOK

  “The outbreak adds to late-cycle risks associated with weakening economic prospects across the region as reflected in our negative outlook for the European banks,” Held said.

  Marioni said that in the US, a large chunk of corporate debt is directly linked to the oil sector.

  Given that the gyrations in crude prices have caused a bumpy ride for oil firms over recent months “the [current] fall in the price of oil will really complicate matters for them,” he said.

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