As New Year 2012 commences the European debt crisis rumbles on, in turn causing economic uncertainty and financial market volatility globally. With no easy or immediate solution in sight this is likely to have sustained implications for the corporate sector.
Debt Mountain
To understand the root cause of this latest crisis one need look no further than the structure of the capital markets. Global debt levels have increased disproportionately relative to economic activity and other asset classes, particularly si nce 2005 when economic growth, benign monetary policy and weak fiscal management combined to provide a powerful catalyst.
A huge debt mountain exists, indeed McKinsey research (link) estimates that global debt totalled USD 158 trillion as at 31.12.2010, equivalent to 266% of global GDP (Graph 1). Contrast this with 2000 when global debt totalled USD 78 trillion or 218% of global GDP. Although not exclusive to Europe, the debt problem is particularly pronounced in the region. The UK ranks as the most indebted nation with Total Debt:GDP of 380% followed by Spain on 342% and France on 308%, these three countries having experienced the fastest credit growth since 1990 (link).
Even conservative Germany breaches the EU’s recommended level of 60% Public Sector Debt:GDP. To add further context, Bank of International Settlements research (link) suggests that debt levels above 90% of GDP are damaging. Benefits from borrowing such as funding growth, smoothing cycles and reducing tax, often short-term in nature, can be outweighed by the longer-term burden of debt service and restricted strategic choices.
Crisis x2
The severity of this crisis has been exacerbated by negative feedback loops. Banks own significant amounts of public and sovereign debt securities thus as the latter’s creditworthiness has declined so banks have suffered direct losses on their holdings.
Moreover the value of collateral and guarantees (what is risk-free now?), often used to secure wholesale and central bank funding, has declined simultaneously. As concerns over bank solvency and liquidity have escalated so sovereigns, perceived lenders of last resort, have been impacted. As ratings actions and uncertainty increase so, inevitably, do volatility and risk premiums. Banks and sovereigns have thus both experienced higher funding costs.
Furthermore in the words of Chancellor Merkel, "there is no silver bullet".
Policy choices are limited and complicated by technical and political trade-offs. Attempts to stem the crisis have thus far failed, the European Financial Stability Facility (EFSF) lacking financial and legal capacity, the ECB intervening modestly to provide bank liquidity and lower bond yields while proposals for a leveraged rescue fund or Eurobond still lack credibility. Without a backstop the crisis has spread, impacting markets globally.
Worryingly, deleveraging will be protracted. The collapse in global demand reduces debt service capacity, indeed some countries may require additional borrowing to support bank re-capitalisation and structural reform. Debt relief, such as the 50% haircut proposed for Greek bondholders or extending maturities remains possible but complicated by credit event triggers and the impact on investor returns and confidence. Inflation appears likely to persist and will, at least, contribute to lower nominal debt levels.
Sustained Implications
Despite its modest growth in leverage over the past decade the crisis has implications for the corporate sector, most notably in liquidity and foreign exchange. Banks already faced significant restructuring to comply with higher regulatory capital requirements to buffer shocks. Whilst most will attempt to recapitalise, many have indicated they will shrink their balance sheets to meet the target (and exit the big bank model?). As in 2009, weaker banks are experiencing reduced access to wholesale funding, increasing the temptation to hoard capital and further restrict lending. The cost of bank borrowing will increase as higher capital and regulatory charges are passed on, simultaneous to the wider re-pricing of risk.
If there is a silver lining for borrowers it is that most developed and emerging countries are signalling a low, or at least stable, interest rate outlook in an attempt to stimulate growth. With the crisis affecting trade flows and, increasingly, capital flows as investors search for safe havens, foreign exchange volatility will persist. Intervention, such as the taxes introduced in Brazil or peg in Switzerland, cannot be excluded as countries seek to maintain competitiveness.
Moreover, if liquidity pressure on the banks persists so central banks will be forced to make further interventions. As we saw with the co-ordinated provision of emergency USD liquidity in September 2011 this can create rapid and unexpected FX movements, hence the speculation as to whether similar intervention will be required in EUR markets.
Act Early
Therein lies the uncomfortable reality, even if uncertainties caused by the crisis can be addressed we still require years of deleveraging to address the primary cause, too much debt. This will require the restructuring of financial markets, economies and government finances thus further bouts of stress are inevitable. Corporates have little ability to influence the discourse. Business models will be impacted and the cost and complexity associated with funding and hedging will increase.
Regardless of your financial position or risk appetite the need for forward planning, good advice and proactive financial management is here to stay.
Neil Mathieson 07.01.2012