Corporate Sector Debt in Peripheral Europe Another Big Concern

Corporate sector finances in Europe have not gotten the same attention as sovereign or bank balance sheets as the euro crisis has evolved. Yet addressing debt levels among Eurozone (EZ) corporates represents another hurdle the EZ must cross before returning to economic health. The hurdles are disproportionately larger in peripheral Europe, exacerbating their recovery challenges.

Global and EZ financial and market conditions have improved in the last six months through policy commitments, renewed monetary stimulus and continuous ECB liquidity support.  Future improvements in the EZ will require both balance sheet repairs in the financial sector, and smooth reduction of private and corporate debt overhangs.  Overall a sustainable recovery will depend on credit conditions and the prospects of fast – but not disruptive – deleveraging of the corporate sector.

Large firms in the EZ area have access to global financial markets or global intermediaries.  In contrast, Small and Medium Enterprises (SMEs) depend heavily on traditional bank financing, a sector that has been has been impacted by the crisis. Small firms create more than 85% of the net new jobs in the EZ, but since the beginning of the crisis small firms have lost jobs faster than large firms.  This is an acute problem in peripheral countries where low domestic demand and the continued emigration of well-educated people has worsened recovery prospects in national economies.

Given the sovereign debt crisis, the supply of credit by banks and financial institutions has declined in the past three years with bank lending in the non-financial sector declining at 4-6% per year (excluding Germany).  Naturally, credit supply is tighter and interest rates for corporate loans are higher in the periphery, reflecting increased costs of funding for banks confronted with NPLs.   The higher costs of funding and restricted supply of credit hinder the recovery, especially for SMEs.  SMEs in peripheral countries are even more important than EU averages would indicate, in terms of employment and value added to national economies.

In addition, excessive corporate leverage – a result of past borrowing to accommodate growth – and current reduced economic activity pose challenges for the corporate sector. Corporate debt levels now have doubled since 2003 and are higher in the periphery than in the core economics. Corporate debt as a share of GDP has reached excessive levels, and again this is especially true in periphery countries.

In the current economic environment two parameters influence the health of the corporate sector in the EZ area. First, corporate debt sustainability, that is, the capacity of firms to generate free cash flow to keep debt at same levels despite declines in revenues and at the same time maintain capacity to make appropriate investment decisions. Second, the ability to service debt, as reflected in the interest coverage ratio, or how many times the interest payments are covered by corporate earnings.

Only 8% of the companies in core EZ countries are considered at risk ( interest coverage ratios less than 1).  In contrast, more than 40% of the companies in periphery EZ countries are at risk of default.   In addition, more than 20% of the firms in periphery EZ countries experience high leverage and low interest coverage ratio; approximately 40% of the firms maintain high leverage and negative cash flow.  Certainly, these statistics present a negative picture for employment prospects and economic recovery.

Debt sustainability scenarios point to the need for corporate deleveraging in the EZ area to avoid bankruptcies. This needs to come from three mechanisms: sale of assets to higher value users, cuts in operating and capital expenditures, and drastic debt reductions.  Studies show that during the coming 3 years, on average, the corporate sector in EZ countries should reduce capital expenditures by 10% and debt levels by 8%.

The impact of the EZ Crisis has asymmetric effects on the corporate sector for core and periphery countries.  Large credit spreads between core and periphery countries have created asymmetries in financing structures for corporations operating within the Eurozone. While the EU is an open free market with mobility of capital and products, companies in the periphery face increasing financing expenses as a result of a country-specific debt premium.  Working capital is more expensive due to limited bank lending.  As a result companies in the periphery that cannot access directly international capital markets have limited ability to reduce funding costs.

Already a large number of SMEs are exhibiting signs of financial distress. SMEs in periphery countries are placed at an even larger disadvantage compared to core-based firms and thus experience loss of competitiveness.  In the short term, consolidation of the corporate sector in periphery countries may create local subsidiaries of large core country-based companies which will have the ability to finance periphery country-subsidiaries with inexpensive funds from core country financial institutions.  This consolidation may generate conditions for economic concentration in several industries, market power and lack of competitiveness within the Union.  If non-Eurozone companies participate in the consolidation process, the inefficiencies in the market place will be less as assets and processes will be transferred for higher value users.

The sovereign debt crisis in the EZnone has created pressures in the banking sector followed by an evolving and escalating crisis in the corporate sector for periphery country firms.  Efforts to contain the crisis have yielded to bank recapitalizations in periphery countries and and structural reforms. However, uncertainty remains ahead as corporate debt sustainability and high leverage are still unresolved issues  for periphery countries firms.

Speaker / Author

George Tsetsekos, Ph.D.

Francis Professor of Finance and Dean Emeritus Drexel’s LeBow College of Business

Dr. George Tsetsekos, serves as the Francis professor of Finance and Director of the Risk Management Center at the LeBow College of Business. He served as Dean of LeBow (2002-2012) and under his transformative leadership the college achieved national rankings and quality milestones in research and teaching. Prior to his appointment as Dean, he served as Drexel’s Vice Provost and Vice President for academic administration and contributed to the completion of the strategic merger between Drexel and MCP Hahnemann University. Dr. Tsetsekos’ extensive research covers the broad areas of corporate finance, investments, banking and international finance. His research contributions include articles ... Read More