As much as 20 percent of non-bank corporate debt in the weakest euro-area economies is unsustainable and may force companies to cut dividends and sell assets, dealing further blows to investor confidence, the International Monetary Fund said.
Businesses in Italy, Spain and Portugal have the largest “debt overhang,” according to the IMF’s Global Financial Stability Report released today, which analyzed 1,500 publicly traded non-financial European firms. Strains in the corporate sector may in turn hurt banks’ asset quality, the report showed.
“Firms in the euro-area periphery have built a sizable debt overhang during the credit boom, on the back of high profit expectations and easy credit conditions,” the IMF said. Now they “face the challenge of reducing the debt overhang in an environment of lower growth and higher interest rates, in part related to financial fragmentation in the euro area.”
European policy makers are struggling for ways to give companies in the so-called periphery access to affordable credit even after the European Central Bank’s plan to purchase bonds of debt-burdened countries. The IMF report defined the periphery as Cyprus, Greece (GDBR10), Ireland, Italy, Portugal and Spain.
Investors have shown their appetite for European corporate bonds with the extra yield they demand to hold the securities rather than government debt declining to 135 basis points, or 1.35 percentage points, as of yesterday from 217 basis points a year earlier and an all-time high of 463 in March 2009, according to the Bank of America Merrill Lynch Euro Corporate Index. The debt has returned 1.23 percent this year, compared with 1.46 percent on a global index.
The default rate on speculative-grade European corporate bonds fell to 1.8 percent in the first quarter from 2 percent in the three months ended Dec. 31 and 3.3 percent a year earlier, Moody’s Investors Service said April 8. High-yield, high-risk, or junk, bonds are rated below Baa3 by Moody’s and lower than BBB- at Standard & Poor’s.
The Washington-based fund lowered its global growth forecast yesterday and called for “aggressive” monetary policy in the region, which is set to contract for a second year and lag behind the rest of the world.
“A key action needed is to fix the euro area, to fix it once and for all,” Jose Vinals, the director of the IMF’s monetary and capital markets department, said at a press conference in Washington today.
European officials need to complete repair of their financial industry and move toward a banking union, Vinals said. If banks in the periphery could get better funding conditions in capital markets, companies would in turn benefit from lower borrowing costs, he said.
The IMF describes a debt overhang as a burden that generates such large interest payments that it prevents companies from investing in profitable projects that would enable them to reduce debt on their own over time.
“While large diversified companies may sell assets -- including foreign units -- to reduce leverage, potential profitable sales are likely to negatively affect their revenues and earnings,” the IMF said. “Furthermore, additional cuts in operating costs, dividends and capital expenditures may also be required, posing additional risks to growth and market confidence.”
While financial risks have abated in the euro region and around the world after the ECB’s commitment to save the monetary union and additional debt relief for Greece, some banks still face high funding costs and deteriorating asset quality, the IMF said.
“Spring has also arrived to global financial markets, where after very rainy days and threatening clouds we are beginning to see some blue sky and more sunny days,” Vinals said. The improvement won’t be sustained “unless policy makers address some key underlying vulnerabilities,” he said.
Contagion from developments in Cyprus was a reminder of how fragile the recovery is, according to the IMF, which has pledged about $1.3 billion toward the country’s international rescue package.
“Although the adverse reaction to increased risk has not been intense in all markets, there was a renewed flight to safe assets and a selloff in some euro area assets,” it said, citing Greek and Slovenian bonds as examples.
Still, the case of Cyprus, which bowed to demands from creditors to shrink its banking system and write down deposits, is “very special” as the island nation required “exceptional measures,” Vinals said. Depositors in the rest of Europe shouldn’t be concerned, he said.
The fund said European banks have so far cut back assets at a pace consistent with its baseline October forecast of $2.8 trillion through 2013, while they reduced their risk-weighted assets more than under that scenario.
“As banks continue to reduce their balance sheets, in addition to cutting back non-core assets, banks may need to restructure or shrink their loan books, which may be more challenging,” the IMF wrote.
The report also analyzes the impact of central banks’ unconventional monetary policies such as asset purchases, saying the strategy of the developed world renews risks of overheating.
With the Bank of Japan’s decision earlier this month to embark on record easing, the world’s four biggest developed-market monetary authorities -- the BOJ, the U.S. Federal Reserve, the European Central Bank and the Bank of England --are aligned in their commitments to spur growth and return their economies to full strength.
“Asset price pressures are likely to grow further over time in the presence of abundant global liquidity,” the report said.
While unorthodox monetary tools are providing support for demand, “a prolonged period of low interest rates and continued monetary accommodation could generate significant adverse side effects,” the IMF said.
That may lead to riskier investments by U.S. pension funds and insurance companies looking for better asset returns, the fund said.
“At the weakest funds, asset allocations to alternative investments grew substantially to about 25 percent of assets in 2011 from virtually zero in 2001, translating into a larger asset-liability mismatch and exposing them to greater volatility and liquidity risks,” according to the IMF.
While the fund saw few signs of asset-price bubbles, it mentioned signs of overheating in real-estate markets of some European countries, in Canada and in some emerging markets.
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