Rising Corporate Debt and its impact on Global Financial Markets
By Rosetta Tamela, Senior Manager Commercial & AR, Massmart Holdings
Reduced Profitability: Higher debt levels increase interest payments, which directly reduce a company's net income and profitability.
Increased Risk of Default: Companies with high debt burdens are more vulnerable to financial distress, especially when interest rates rise or economic conditions worsen, potentially leading to bankruptcies.
Shift from Investment to Shareholder Returns: A significant portion of increased corporate borrowing has funded share buybacks and dividends rather than new investments, slowing productivity growth and economic expansion.
Reduced Investment and Growth: High levels of corporate debt can restrict companies from taking on new debt, limiting their capacity to invest in new projects and grow.
Slower Economic Growth: Higher interest rates, driven by increased debt and refinancing risk, can hamper overall economic growth by making borrowing more expensive and reducing investment. When debt is used for financial engineering rather than productive investment; it can hamper economic growth by reducing capacity for future expansion.
Refinancing Risk: A significant portion of outstanding corporate bonds is set to mature in the next few years, and with higher borrowing costs, firms face increased risk in refinancing their debt.
Transmission of Shocks: Banks can act as channels for transmitting global economic shocks, such as the recent credit supply shock, to other emerging economies through high corporate debt levels.
Potential for Financial Crisis: Accumulation of high levels of nonfinancial corporate debt could trigger a financial crisis comparable to the Global financial crises.
Stricter Risk Appetite: Banks are likely to become more cautious with their risk appetite due to concerns about the credit quality of hard-hit borrowers and their own profitability.
Loan Restructuring: To support distressed companies, banks may offer loan modifications, debt extensions, or other forms of support to help businesses manage high leverage and avoid default.
Liquidity and Capital Management: Banks manage their liquidity and capital adequacy levels to maintain stability, ensuring they have sufficient high-quality liquid assets (HQLA) to meet obligations.
Monitoring External Factors: Banks closely monitor external factors such as commodity prices, foreign exchange volatility, and global monetary conditions that can significantly impact the health of corporate borrowers.
Lending Standards: Banks may tighten lending standards to ensure they are lending to borrowers with sufficient earnings to cover debt interest payments, thereby mitigating future downside risks.
Systematic Risk Management: The banking sector must balance the need to support economic growth with the imperative to contain future downside risks associated with high and rapidly building corporate leverage, according to reports from institutions like the IMF. Worsening loan quality exposes banks to greater financial and systemic risk, creating a potential drag on overall financial stability. A widespread increase in corporate distress and defaults, especially if concentrated in certain sectors or economies, can pose a systemic risk to the broader financial system
Higher Funding Costs: Banks may face higher costs to fund their own operations, which can be passed on to borrowers, further increasing the price of credit for firms and consumers
Emerging Market Vulnerabilities: The banking sector in emerging markets faces heightened vulnerability due to high leverage and rapid debt growth, with a significant proportion of debt denominated in foreign currencies, making them susceptible to currency fluctuations and tightening global financial conditions. Emerging markets with high corporate debt are particularly vulnerable to capital outflows, currency depreciation, and increased inflation expectations when global interest rates are high.
Corporate Fragility: Emerging Market for corporate fragility. The measure is composed of various income statement and balance sheet items: the ratios of working capital, retained earnings, and operating income to total assets, as well as the book value of assets to total liabilities. By combining various aspects of firm operations, it paints an overall picture of corporate health.
High levels of debt in emerging markets are a major source of concern among policy makers. The situation would be more concerning if the carry trade motive was the main factor driving these debt levels because currency exposure magnifies fragility; however, when the save-to-invest motive is more widely considered, financial stability risks are less pronounced. Although firms would not be using their balance sheet to arbitrage interest rate differentials, such action could still lead to financial fragility
The main contribution is to show that the save-to-invest motive has been an important force behind the expansion of corporate bond issuance in emerging market economies during the second wave of global liquidity, while the evidence on carry trade seems to show companies taking advantage of good financial conditions abroad rather than taking advantage of financial arbitrage.
Critical management of Debt Maturity Profile, it has been evident from transaction-level data shows that the increasing reliance of emerging market firms on debt markets has been associated with long-term maturities, However it is important to have diverse maturity profile between long term and short-term borrowings as well balance between fixed and floating to manage market volatility risk
Macroprudential Tools: Central banks and supervisors use macroprudential instruments like the countercyclical capital buffer (CCyB) to build financial system resilience against potential downturns when the credit-to-GDP gap exceeds certain thresholds. Credit Risk Monitoring: The Reserve Bank of South Africa uses the credit-to-GDP gap as an early warning indicator of systemic risk, providing insights into rising credit risk.
Debt at risk measures for listed and unlisted firms show that the overwhelming majority of debt could be at risk and adversely impact the banking sector when future prospects are taken into account
Stress Testing: Banks and regulators perform stress tests to assess the vulnerability of their portfolios to economic shocks, ensuring that they can withstand potential losses. Higher corporate debt levels can lead to a decline in the credit quality of corporate loans held by banks.
To mitigate global corporate debt, governments can promote fiscal responsibility and transparent reporting, facilitate debt restructurings, and develop resilient markets for securities. Corporates to reduce their debt by refinancing, consolidating high-interest debts, and carefully managing new borrowing to ensure it generates sufficient returns. For low-income countries, increasing alternatives to borrowing, improving borrowing and lending practices, and enhancing accountability are also crucial strategies. Furthermore, Corporates and Businesses need to:
Understand and Prioritize Debt:
Fully understand the types of debt held and prioritize paying off high-interest debts first to reduce overall costs. ( e.g settling of an expensive debt first, refer to old money vs new money)
Refinance and Consolidate:
Explore options to refinance or consolidate multiple debts into a single loan, potentially at a lower interest rate, to simplify repayments and reduce costs.
Strategic Borrowing:
Carefully consider new debt to ensure it is strategic, can generate returns that exceed the cost of borrowing, and doesn't add an undue current burden. (You will hear Corporate leaders saying I’m bleeding Cash, when repaying debt)
Set Clear Financial Goals:
Establish clear financial goals and track progress to pay down debt, rebuild savings, and regain control over the company's finances.
Corporate Benefits on diversifying revenue streams:
Financial Cushion
Cash reserves provide a buffer to cover operating expenses, ensuring business continuity during unexpected downturns or revenue shortfalls.
Liquidity
Cash readily available allows businesses to meet obligations like payroll, rent, and supplier payments, even during challenging times.
Strategic Investments
Cash reserves provide the flexibility to invest in growth opportunities, such as acquiring new equipment or expanding into new markets, when they arise.
Reduced Risk
A strong cash position reduces reliance on debt and allows businesses to weather financial storms with greater confidence.
Revenue Enhancement: Explore strategies to boost revenue
Cash is King: while revenue & profitability is very crucial for long-term success, it's cash that fuels daily operations, sustains growth, and ensures survival of the business.
| BENEFITS | RISKS |
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Balancing the risks with the benefits requires careful planning and strategy. Finance and Business Leaders need to ensure that reserves allows the business to maintain both liquidity and operational efficiency. This ensures that cash reserves support growth rather than hinder it.
Economic volatility is inevitable globally in business world, as it is driven by unpredictable fluctuations in economic conditions that impact Corporate performance, like
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