Euro corporates face sovereign risks
For European corporate borrowers, having their own houses in order may prove little help as sovereign credit-worthiness deteriorates.
European nations need to fund more than a trillion euros in debt in the coming year to finance shortfalls caused by falling tax receipts, countercyclical stimulative spending, and plain old bad management.
As we have seen in Greece, at the worst this funding is not available from the market, but even relatively stronger nations like France have substantial funding needs stretching out as far as the eye can see.
This opens up the possibility that private borrowers, banks and corporations alike, may be “crowded out” of debt markets, as sovereign borrowers suck up the available credit.
That would drive up the cost of financing for corporations, making investment, hiring, and production less attractive. As banks in Europe are particularly reliant on external, short-term non-deposit funding a bout of crowding out could have nasty consequences for global financial stability.
“All in all, excessive public deficits and rising debt-to-GDP ratios may pose upside risks for sovereign and corporate bond yields in the euro area,” according to the European Central Bank’s Financial Stability Review, published on Tuesday.
Taken together, a range of factors “have the potential to reinforce negative feedback loops between the financial and real sectors, with an adverse impact on economic growth and on the stability of financial systems”.
Public debt markets have been a lifeline for euro zone corporate borrowers facing tight lending conditions from banks, and have played a key role in not just keeping banks lending but keeping them standing upright.
European non-bank corporations are highly leveraged but can take some comfort from improving earnings and, at least currently, a very low cost of funding driven by ultra-low central bank interest rates.
Euro area corporations were paying out 6.3 percent of their current income in interest expense at the end of 2009, a bit lower than the long run average.
Debt levels are high, however, with debt-to-equity at a 10-year high of 70 percent. That leaves them open to an interest rate shock if market rates rose in reaction to a sovereign funding scare.
European banks are worse off. Having made less progress in rebuilding equity and writing down doubtful assets than their U.S. competitors, they now face a funding bulge, with 800 billion euros in long-term debt that will have to be refinanced by the end of 2012. Bank borrowing has already suffered because of sovereign concerns, as shown by rising tensions in the interbank lending market.
MULTIPLE CHANNELS OF TRANSMISSION
Even if you doubt, as many do, that crowding out will happen with an economy still operating at well below its normal capacity, sovereign risk could upend corporate borrowing in several other ways.
Banks, of course, can be hit not just by the effect of higher funding costs, but by deterioration in their asset base.
Euro zone banks are huge holders of euro zone government debt, in part because they have been encouraged by ECB emergency policy to do so. I have argued in the past that the reason Greece has not been allowed to partly renege on its debts, despite the fact that it seems both warranted and inevitable, is that there is non-trivial chance that doing so would cause a run on banks, and not just Greek ones.
“On the day that the rescue package was agreed on, shares of French banks rose by up to 24 percent. Looking at that, you can see what this was really about — namely, rescuing the banks and the rich Greeks,” former German Bundesbank head Karl Otto Pohl told Der Spiegel.
Inflation risk premia may rise, which can drive funding costs higher, though if you are a Greece supported by a credible euro zone you may skate past this particular issue. If government debt issues affect inflation risk perceptions for the whole of the euro zone, then it won’t just be a Greek of Italian borrower who must pay extra.
Many of the risks the ECB discusses are, to varying degrees, technical but the true risk for euro zone borrowers, and perhaps in coming months for British ones too, is fundamental.
The austerity programmes now being mooted in the euro zone will dampen consumption, investment and growth. The euro zone, or at the very least large swaths of it, could find themselves in another recession.
That will hit revenues making higher risk premiums justified. If it happens at the same time as a spike in interest rates, or even some sort of a rollover crisis for banks and sovereigns alike, it would be a systemic threat, rather than just a hit to corporations and bondholders.