We’ve all feared a debt crisis for years as private and public debt hit record levels. The situation has undoubtedly worsened after the COVID-19 pandemic as corporations benefited from plentiful state-guaranteed loans and low-interest rates to strengthen their cash flows.
The tide has since turned: Facing higher-for-longer inflation, central banks had no choice but to tighten their monetary stance. And by starting a bit late, they needed to be aggressive, raising concerns about the prospects of a sharp recession in a climate of high interest rates.
The Means to Avoid
Despite what has turned out to be the fastest hiking cycle since 1999 in the United States and Europe, we should be able to avoid a full-blown debt crisis. Higher interest rates have not impacted the real economy as strongly as they have in the past. Usually, the effects occur within six months, but this time, the interval doubled.
One reason for the lagged effect is that companies and households in the United States and Europe still have billions of dollars in excess cash squirreled away during the pandemic. The latest figures suggest that post-COVID excess cash for corporates stands at $240 billion in the U.S. and more than 850 billion Euros in the eurozone.
The second sign of a lengthy transmission gap is the slow rise in net interest payments. In France, they still remain below pre-pandemic levels at 4.7% of gross operating surplus (against 1.1% in Germany and 3.4% in the United States).
Finally, corporate loans have longer average maturities, and more of those instruments are fixed-rate loans. Corporate margins have remained resilient, and labor hoarding has kept the unemployment rate low.
For now, the stars seem all aligned to avoid a short-term corporate debt crisis.
The Repayment Wall
Despite the rise in interest rates and relatively low economic growth, there has not been massive deleveraging. and the debt risk profile has not improved over the last few months. The average debt/EBITDA ratio has reached a substantial 3.8% in the United States and 3.3% in Europe.
Rates should peak at 5.75% in the United States (the highest level since 2007) and 4% in the eurozone (the highest level since 2001).
At the same time, central banks are not done yet: corporates’ resilience will be tested in the coming months. At Allianz Trade, we expect interest rate hikes until the autumn of 2023. Rates should peak at 5.75% in the United States (the highest level since 2007) and 4% in the eurozone (the highest level since 2001).
The transmission might start to bite toward year-end, especially as companies see their profits squeezed as economic growth falters and pricing power fades. Our calculations show this shock should be equivalent to a 3-point loss of EBITDA margins in the eurozone, for example, and as much as -3.5 points in France and -1.5 points in the U.S.
Increasing indebtedness coupled with declining business margins could definitely lead to a debt repayment wall. What does this mean for CFOs? The good thing is this wall will not be high enough to generate a massive private debt crisis. But the bad news is that some businesses, more than others, are more likely to hit the wall head-on.
This is especially relevant for small and medium-sized (SME) companies in the United States and Europe: 65% of the debt that they hold is due by 2026. During the COVID-19 period, the number of fragile SMEs, i.e., those likely to default in the next four years, was considerably reduced. Now we expect the number of fragile SMEs to return to 2019 levels: 18% in the United Kingdom, 14% in France, 10% in Italy, and 7% in Germany.
Some sectors — transportation, construction, hospitality, commodities, and automotive — will be hit harder because they tend to be more indebted than others. They rely on debt to finance day-to-day operations and have a lower capacity to meet debt commitments.
Directing Debt
Beyond a potential repayment wall, we should worry about how excessive debt levels could fuel inflation. When businesses are heavily indebted, they may be more willing to tolerate higher inflation as it reduces the real value of their debt. And that could tempt them to take on additional debt, which can further fuel inflation, creating a vicious circle.
Despite a year of record profits in 2022, private investments grew by only 3% globally; they should have increased by 30%.
Is endless debt reasonable? Certainly not. But the more important question is how companies should use debt.
Many are cash hoarding first. Despite a year of record profits in 2022, private investments grew by only 3% globally; they should have increased by 30%. While preserving liquidity is understandable in a highly uncertain global environment, we must (re)balance this behavior.
To meet the challenges, businesses will have to invest much more, and policymakers should ensure that the overall environment remains conducive to investment. This is essential to finance sustainable growth, which is the key to successful transitions in areas like green energy and technology overall.
Aylin Somersan Coqui is the CEO and chair of the board of management of Allianz Trade.
