Low interest rates are encouraging companies to take on a level of debt that risks becoming a $19tn (£15tn) timebomb in the event of another global recession, the International Monetary Fund has said.
In its half-yearly update on the state of the world’s financial markets, the IMF said that almost 40% of the corporate debt in eight leading countries – the US, China, Japan, Germany, Britain, France, Italy and Spain – would be impossible to service if there was a downturn half as serious as that of a decade ago. The stimulus provided by central banks in both developed and developing countries had the side-effect of encouraging firms to borrow more, even though many would have trouble paying it back. The IMF fear that the buildup of debt makes the global financial system highly vulnerable. IMF says risk has migrated elsewhere, including to the corporate sector. It believes countries need to look again at giving tax breaks on debt interest payments, which it believes encourages companies to raise money through borrowing.
It said share prices in the US and Japan appeared to be overvalued, while the credit spreads in bond markets – the compensation demanded by investors against risk – seemed to be too low, given the state of the global economy.
Tobias Adrian and Fabio Natalucci, two senior IMF officials responsible for the Global Financial Stability Report, said: “A sharp, sudden tightening in financial conditions could unmask these vulnerabilities and put pressures on asset price valuations.”
Adrian and Natalucci noted: “Corporations in eight major economies are taking on more debt and their ability to service it is weakening. We look at the potential impact of a material economic slowdown – one that is half as severe as the global financial crisis of 2007-08. Our conclusion is sobering: debt owed by firms unable to cover interest expenses with earnings, which we call corporate debt at risk, could rise to $19tn. That is almost 40% of total corporate debt in the economies we studied.”
Adrian and Natalucci said the cheap money policy adopted by central banks was helping to boost financial markets in the short-term but, by encouraging investors to take more chances in the quest for higher yields, risked instability and lower growth in the medium-term.
Over the past six months, they added, vulnerability had increased among financial institutions that are not classified as banks, such as pension funds and insurance companies. Risks were “elevated” in 80% of economies, as measured by GDP, with systemically important financial sectors – a similar level to the height of the financial crisis.
“Very low rates have prompted institutional investors like insurance companies, pension funds and asset managers to reach for yield and take on riskier and less liquid securities to generate targeted returns,” Adrian and Natalucci said.
“For example, pension funds have increased their exposure to alternative asset classes like private equity and real estate. What are the possible consequences? Similarities in portfolios of investment funds could amplify a market sell-off, and illiquid investments by pension funds could constrain their traditional stabilising role in markets. In addition, cross-border investments by life insurers could provoke spillovers across markets.”