by Nick Corbishley, Wolf Street:
Instead of warning about the effects of this absurdity, they could just raise rates and quit buying bonds.
Just two days after French luxury giant LVMH picked up Tiffany & Co. in a €14.7-billion deal, the Bank of France has warned that large French non-financial corporations, many of them part-owned by the state, have been taking advantage of years of low or negative interest rates to take on dangerous levels of debt.
Much of that debt has been used to buy up overseas companies and assets, the central bank warned in a report published in its November monthly bulletin.
Unlike some of their European peers, French firms’ net financial indebtedness (the total amount of debt minus available cash) has continued to rise since the 2008 financial crisis, reaching €3.6 trillion earlier this year, the equivalent of 143% of GDP, having increased more than 30 percentage points in 10 years. That was enough to earn the country eighth place on WOLF STREET’s leader board of the world’s most monstrous corporate debt pileups, just one notch below China in seventh.
The Bank of France’s warning is the latest in a series of dire warnings by central banks about the risks they themselves have created with their QE programs and interest rate repression, while simultaneously doubling and tripling down on QE and interest rate repression — much like a doctor might misprescribe a medicine, then, after the damage has been done, warn the patient about the dangers of taking that medicine, and yet for some reason continue to insist that the patient keeps taking the medicine.
Among the central banks that have issued warnings In the last past two weeks alone:
- The Federal Reserve cautioned that business debt levels are “high compared with either business assets or GDP, with the riskiest firms accounting for most of the increase in debt in recent years”. Around half of investment-grade debt outstanding is currently rated in the lowest category of the investment-grade range (triple-B) “– near an all-time high.”
- The ECB warned that “very low interest rates, coupled with the large number of investors which have gradually increased the duration of their fixed income portfolios, could exacerbate potential losses if an abrupt repricing were to materialize.”
- The German Bundesbank said that negative interest rates are encouraging banks in take on ever greater risks, expanding their lending to “relatively high-risk businesses” while simultaneously reducing their provisions. German lenders have also increased their exposure to the fast-growing domestic real estate market, while the Bundesbank considers house prices in many cities overvalued by 15% to 30%.
Now, it’s the turn of Banque de France to sound the alarm bells concerning the massive, unchecked rise of corporate debt in the country. The interest rate for lending to NFCs averaged 1.56% in 2018, its lowest level on record, according to S&P Global Ratings. This year, the ECB has cut its negative policy rate deeper into the negative. Small and midsize enterprises (SMEs) have used this opportunity to take out bank loans, while large companies have issued debt easily on the capital markets.
Some companies have held on to the extra funds as “dry powder” to fund capital expenditure (capex) needs, or as liquidity reserves to fend off takeover attempts. But many of them have used it to buy back their own shares or go on M&A sprees, often oversees.
“By 2018, 123 of the 215 groups under review had made an external growth investment,” says the Bank of France’s report. Many of the acquisitions have taken place since 2016, when the ECB embarked on its corporate debt purchase program which made it much cheaper for corporations to issue fresh debt. As the report notes, “the burden of this debt will have to be covered by the future revenues released from these acquisitions.” In some cases, however, there is a risk that “anticipated future revenues may be overvalued.”
The problem is not just that the corporate debt pile is growing; it is that it is growing at the same time that many of the companies’ operating profitability is falling. In a core sample of 177 large groups, average operating profitability decreased from 11.1% to 9.8% between 2016 and 2018. As such, many companies’ capital profitability is being driven more by leverage than by operations.
As the firms’ profitability has fallen, their self-financing capacity — their ability to generate growth capital from their own income, instead of acquiring it from external sources such as investors or lenders — has also deteriorated. According to the Bank of France, in 2013 it took theoretically an average of two and a half years of self-financing for a company to repay its debts. By 2018, it was up to three and a half years.
By increasing their debt leverage as their profitability falls, French corporations are putting themselves at huge risk in the event of a sudden rise in interest rates. “The repayment capacity would deteriorate significantly,” the report warns. While such a risk may not be of immediate concern, it could become a long-term issue.
If rates do suddenly rise, there is a further cause for concern: companies’ liquidity buffers, which are now at their lowest level since the financial crisis. Among the large companies analyzed by the Bank of France, the average cash to equity ratio — the ratio of a company’s cash on hand against the total net worth of the company — has steadily declined since 2012. At last count, in 2017, it was just 21%, compared to 27% in 2009. Even in 2007, on the very eve of the last crisis, it was 22%.