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Which countries face corporate balance sheet vulnerabilities? a novel monitoring framework

Erik Feyen's picture

The debt of the nonfinancial corporate sector in emerging and developing economies (EMDEs) has risen significantly since the global financial crisis, raising concerns about financial stability and spillover risks. While monetary easing in developed economies has allowed EMDE corporates to raise substantial financing from global capital markets, the sharp decline in commodity prices since 2014 and lower growth prospects across EMDEs have weighted on their firms’ profitability and debt service capacity.

The current global environment raises questions. How vulnerable is the current financial situation of the EMDE corporate sector?  How has it evolved since the global financial crisis?

In a recent paper, we introduce the Corporate Vulnerability Index (CVI), a novel monitoring framework that tracks the financial conditions of the nonfinancial corporate sector in EMDEs. Using the available balance sheet information of 14,207 listed nonfinancial firms in 69 countries, the CVI is based on seven indicators that capture four dimensions of firms’ financial vulnerabilities: debt service capacity, leverage, rollover risk, and economic performance. The seven indicators are the interest coverage ratio (ICR), leverage ratio, net debt–to–earnings before interest and taxes ratio, current liabilities–to–long-term liabilities ratio, quick ratio, return on assets (ROA), and market-to-book ratio.

The CVI is based on the concept of “debt at risk” (DaR), the total amount of outstanding debt in a country associated with firms that are deemed financially vulnerable. DaR is an attractive concept for tracking corporate vulnerabilities, as it exposes the risk and magnitude present in the tail of the firms’ financial risk distribution function.

For each of our seven indicators, we consider a firm as financially vulnerable if the value of each financial indicator falls below (or above) a certain threshold, which is calculated as the bottom (top) 10th percentile value of the respective indicator for firms within the same industry. For the ICR, we additionally consider the value 1 as a critical threshold.

An important innovation of our approach is applying the DaR concept to multiple financial risk indicators. We assume that firms are riskier if they face vulnerability from more than one financial risk dimension. For instance, a company with an ICR < 1 and low ROA is more vulnerable than a firm with low ROA but ICR > 1. In our approach, debt at risk (DaR>=X) captures the proportion of corporate debt in a country that is held by firms that are vulnerable according to X or more of the abovementioned indicators simultaneously, in which X can have values from 0 to 7.

The CVI can take on values between 0 and 1. A value of 0 indicates that no firms are vulnerable according to any of the seven indicators, and a CVI of 1 means that all firms are vulnerable according to all of them.

Corporate vulnerability has risen but stabilized in recent years

The debt of nonfinancial firms in EMDEs has increased in level and riskiness (figure 1). EMDEs’ corporate debt increased by 55 percent, from US$2.6 trillion to US$4.1 trillion, between 2010 and 2017Q2. DaR>=1 grew by 210 percent, from US$1 trillion to US$2.9 trillion, equivalent to 71 percent of total corporate debt in 2017Q2.

Figure 1: Total Corporate Debt and Corporate Debt at Risk (US$ billion)

 Total Corporate Debt and Corporate Debt at Risk (US$ billion)

Source: Authors’ calculations based on Bloomberg financial information.
Note: DaR refers to debt at risk. Data for India are as of 2016Q4.

At the global level, the CVI suggests that corporate vulnerability has risen sharply since 2013 but appears to have stabilized in 2016–17 (figure 2). This global trend is caused by an increase in leverage and a deterioration in both profitability and debt service capacity. However, regional trends are more heterogeneous. Corporate vulnerability in Europe and Central Asia had been elevated since 2007 but was reduced in 2017. The Latin America and the Caribbean region shows a rapid increase in vulnerability since 2013. Other regions show a slight increase in vulnerability between 2016 and 2017, associated with an increase in leverage, reduction in earnings, and lower profitability (figure 3).

At the industry level, we find that particularly energy-linked sectors have experienced rising financial vulnerability, especially since the 2014 fall in global oil prices.

Figure 2: Global Corporate Vulnerability Index

 Global Corporate Vulnerability Index

Source: Authors’ calculations.
Note: Global country median. 75th and 25th percentiles in dotted lines.

Figure 3: Regional Trends in Corporate Vulnerability

 Regional Trends in Corporate Vulnerability

Source: Authors’ calculations.
Note: Country median by region.

Our results further suggest that the CVI has leading indicator qualities. Using weighted logit regression models, we find that an increase in the CVI is positively associated with a future rise in unemployment and a gross domestic product recession.

Window of opportunity for EMDEs

If the current relatively benign global funding conditions and higher commodity prices endure, companies in EMDEs may have an opportunity to strengthen their balance sheets. These conditions are also a window of opportunity for governments and policy makers to examine the efficiency of EMDEs’ institutional and policy frameworks for monitoring vulnerabilities and dealing with distressed firms in case adverse shocks materialize.

For more information, please read our paper here.

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