IMF Survey: Why the concern about high euro-area corporate debt?
Jaeger: The recent sharp rise in the area’s corporate indebtedness could have adverse effects on euro-area investment. Theory holds no clear answers on this question. One theoretical benchmark suggests that corporate leverage should not affect investment. Or, as it is sometimes put, corporate investment decisions should not depend on how the liability side of the balance sheet is sliced up into debt and equity. But other models of corporate investment behavior argue that more leveraged corporations will find it more difficult or costly to obtain financing than corporations with identical investment projects but sounder leverage positions.
The conventional wisdom about a year ago was that U.S. corporations sorely needed to clean up their balance sheets—implying cuts in capital spending, taking a hard look at whether past financial acquisitions made sense, and reducing labor and other costs. By contrast, euro-area corporations were viewed as being in relatively good shape. Operating profits in the euro area seemed to be quite high compared with levels during previous downturns, and capacity utilization rates were close to the historical average, suggesting that the area’s investment overhang (an excessive buildup of capital during a boom) was limited. But corporate investment in the euro area was as anemic as in the United States, with no clear signs of picking up. This pointed to the possibility that over-leveraged corporate balance sheets were the main brake on investment spending. Corporations seemed to prefer to use their cash to repay debt rather than to invest.
IMF Survey: Why was it not apparent earlier that deleveraging played a role in constraining euro-area investment?
Jaeger: Leverage is usually not considered a prime culprit in shaping business cycles—macroeconomic policies and the links between profits, investment, and credit are viewed as more important. In the euro area, pertinent data were also in short supply. The European Central Bank started publishing sectoral balance sheet data in August 2002. Once these data became available, it was quite clear that euro-area and U.S. corporations had gone through similar corporate boom-bust cycles and associated balance-sheet dislocations.
IMF Survey: What was the extent of the recent boom-bust cycle in euro-area equity valuations, and how much leverage did euro-area corporations take on?
Jaeger: At least from the point of view of postwar data, the rise and fall in equity valuations seem to have been unprecedented: in 1995, euro-area corporate equity was worth the equivalent of about 70 percent of the area’s GDP; valuations mushroomed to more than 150 percent of GDP in 1999 but then fell to about 95 percent of GDP in 2002. This boom-bust cycle very closely mimicked what we saw in the United States. And while the technology sector accounted for a lot of the volatility in the area’s equity valuations, the boom was by no means a mere hightech bubble. Measures of leverage suggest that once the boom reversed, it rose sharply. For example, before the boom started, corporate debt was about 60 percent of GDP. By the end of 2001, it had risen to about 80 percent of GDP.
IMF Survey: At what point does a corporation’s balance sheet become “overleveraged”? Why is this of concern?
Jaeger: Defining “overleverage” for corporations is a bit like defining “overweight” for people. There are useful rules of thumb in both cases. The corporate finance literature offers two competing paradigms of what corporations consider to be a normal leverage position; the key distinction is whether corporations look at leverage as a flow or a stock issue. The trade-off paradigm looks at leverage as a stock issue and predicts that corporations have well-defined targets for their desired debt-equity mix. In determining this mix, firms weigh the benefits and costs of debt, trading off the tax and incentive benefits of debt financing against the expected cost of financial distress. If a boom-bust equity cycle dislocates their financial structure, corporations try to move the mix back to target.
By contrast, according to the pecking-order paradigm, firms generally prefer internal to external finance, while among external financing options, they prefer first to use safe debt, then risky debt, and finally, as a last resort, equity. This paradigm looks at leverage as a flow issue and predicts that corporations care mainly about the sizes of their financing flows, particularly internal versus external. The debt-equity mix in stock terms is then largely an accident of history.
The bottom line is that balance-sheet adjustments under the trade-off paradigm could take pretty long because the corporation would have to move back to a stock rather than a flow target.
IMF Survey: Should we be more worried about the impact of corporate indebtedness on investment?
Jaeger: There are certainly good reasons to keep an eye on corporate balance sheets. In addition to my earlier comments, two more points seem relevant. First, whether corporations view themselves as over-leveraged and, as a consequence, hold back on investment may also depend on specific experiences. For example, when corporate bond markets virtually closed down in mid-2002 following the WorldCom scandal, even some big-name corporations seemed to have come close to bankruptcy. That kind of experience could have made corporations much more cautious in judging what constituted a sound leverage position. Second, the speed of the balance-sheet adjustment process also seems to depend on the type of financial system that a corporation is facing. The euro area’s financial system is largely bank-based, and relationship lending could mean that adjustment pressures are less pronounced than in systems largely based on capital market intermediation. By the same token, however, the adjustment process could also take longer under a bank-based system.
IMF Survey: What is the general prognosis for euro-area recovery?
Jaeger: The baseline of most forecasters is a gradual recovery, starting in the second half of 2003. But this assumes that corporations’ balance-sheet adjustments have largely run their course. There are indeed encouraging signs that euro-area corporations have made considerable progress in strengthening internal cash flows and cutting back on external financing. Moreover, low nominal interest rates provide a helpful backdrop. Nevertheless, present baseline forecasts seem to be premised on the assumption that the pecking-order paradigm is on the mark. However, if one believes the trade-off paradigm is more relevant, one would have to assume there are downside risks to the baseline forecast. After asset price booms, downturns tend to be quite protracted, particularly in low-inflation environments. It’s also a fact that forecasters don’t have a great record in projecting growth in this type of macroeconomic environment.
IMF Survey: What are the policy implications of your findings?
Jaeger: Macroeconomic policymakers should be supportive of the adjustment process but may also have to be patient. As regards monetary policy, providing a low-interest rate environment coupled with an accommodative bent in the policy outlook is important. On the fiscal side, recourse to brute-force reflation, advocated by some, is unlikely to work and could well have the perverse effect of destroying the credibility of the euro area’s existing fiscal framework. In the euro area’s particular case, tackling structural reforms that boost medium-term growth prospects could make a significant contribution by increasing expected profit opportunities for investment.
Copies of IMF Working Paper No. 03/117, “Corporate Balance Sheet Restructuring and Investment in the Euro Area,” by Albert Jaeger, are available for $15.00 each from IMF Publication Services. Please see page 303 for ordering details. The full text is also available on the IMF’s website (http://www.imf.org).