Summary
– Eurozone companies have entered a cycle of deep deleveraging, with highly indebted countries such as Spain appearing to have made the greatest efforts.
– The deleveraging process in Spain involves increasing margins and savings, while relying on improved competitiveness.
– The goal of deleveraging is to reassure investors about the financial health of companies and thus promote the return of employment and demand, thereby triggering a virtuous circle.
– However, the example of Japan in the 1990s presents another type of scenario in which a very dangerous deflationary cycle takes hold in European economies.
Deficit, public debt, spending cuts, austerity… These are the concepts that have been dominating economic news in the eurozone on an almost daily basis since the beginning of the crisis in the late 2000s. Vigorously combated in the years leading up to the crisis and regulated by legislation (with varying degrees of effectiveness), public debt, the « public enemy number one, » has been the focus of attention… to the point of neglecting private sector debt, particularly corporate debt.
From Spain to the Netherlands, via Portugal, Ireland, and Italy, corporate debt has been a determining factor in the crisis.[1]. This is particularly evident in Spain, which was certainly a model student in the Eurozone in terms of public finances during the 2000s, but where the accumulation of credit (up 132% between 2000 and 2006) and excessive corporate debt (especially in the construction sector) were significant enough to jeopardize the Spanish economy as a whole[2].
Spanish companies at the center of private sector deleveraging in the Eurozone
Since 2010, Spanish companies have entered a phase of deleveraging. Based on the latest available figures, they appear to be on the right track, gradually reducing their debt stock more quickly than their Irish, Portuguese, and Dutch neighbors: the debt-to-GDP ratio fell by 6 percentage points between the first quarter of 2010 and the first quarter of 2012, compared with an average change of -1 percentage point for the other three countries mentioned. Over the same period, in terms of debt reduction, Spain recorded a 3% decline, compared with an average of close to 0% for the other so-called peripheral countries (Ireland, Portugal, Greece, and Italy). Admittedly, the level of debt remains high (the debt-to-GDP ratio was 122% in Spain, compared with 81% in Italy, 168% in Ireland and an average of 101% in the eurozone), but as it is impossible to determine an optimal level, only the pace of debt reduction can be used to judge the efforts made by Spain.
How did Spanish companies achieve such results? The increase in the margin rate (EBITDA/VA) and the increase in added value were made possible by productivity gains.
The distribution of added value has been distorted between gross payroll and gross operating surplus (EBE). Gross payroll has been reduced by a decrease in employer contributions and a contraction in the number of employees (a large proportion of whom are on temporary contracts). The decrease in gross payroll thus reduced labor costs per unit produced (decrease in gross wages, with production levels unchanged) and increased productivity per capita (reduction in staff, with production levels unchanged). The increase in the margin rate was automatically achieved by a decrease in the level of gross payroll.
From 2008 to 2009, the economic situation led to a contraction in economic activity, resulting in a decline in production, which contributed more significantly than intermediate consumption to a reduction in value added. From 2009 onwards, the recovery in activity was accompanied by fiscal measures that stimulated a decrease in the cost of intermediate consumption. Growth in value added thus exceeded growth in production.
The growth in profit margins, which exceeded the growth in value added, was used by Spanish companies to reduce their debt (both exporting and non-exporting companies) and to lower prices on the international market (exporting companies). The latter solution made it possible to maintain market share in Spain and stimulate external demand.
This development, combined with the adjustment in employment, led to a 35.6% increase in EBITDA [3]between 2006 and 2011. Faced with a banking system in crisis, unable to supply the real economy with credit, and turbulent markets (where risk premiums were significantly revised upwards), sources of external financing dried up considerably. Companies then relied on their margins to save more and thus self-finance (self-financing rate above 100% since 2010) and reduce their debt.
Overall, in terms of trajectory, Spain is currently the country that is most effectively purging its debt stock, and all hopes now rest on a return of investment that would trigger the following virtuous circle:
However, it is very difficult to know whether the countries of the Eurozone, and more particularly Spain (which seems to have embarked on a more profound process[4] ), are really making progress in reducing their debt. Countries that are only at the beginning of the cycle (Portugal, Italy, Austria) still have a long way to go and will first need to regain positive financing capacity. In countries where the adjustment process has been underway for longer (Spain, the Netherlands, Ireland), the stage of « access to sources of financing and return to investment » has not yet been reached, and it is currently difficult to anticipate the investment behavior of companies. It is even possible that this stage will not occur in the near future, at least not in the short to medium term, and will be preceded by other events (or stages) with certain undesirable effects.
Deflationary risk and the Japanese example: a lesson for Spain
As we have just seen, deleveraging should lead companies to stimulate the economy by establishing a virtuous circle. However, it could also lead to the opposite situation, where economic recovery is far from guaranteed. Japan in the 1990s is a typical example of a country where corporate deleveraging did not lead to a recovery in investment and economic activity. Moreover, the characteristics of the crisis in Japan in the 1990s are quite similar to what has been observed in Spain.
In 1990, Japan experienced a very serious financial crisis: a real estate bubble and a banking crisis.[5]and stock market crisis. Between 1985 and 1990, companies benefited from broad access to credit thanks to an accommodative, highly expansionary monetary policy (the Bank of Japan’s key interest rate was below 2.5% until 1989). Until 1995, the debt-to-GDP ratio of Japanese companies gradually increased to 155% of GDP, at which point indebted firms changed their strategy and entered a phase of debt reduction. This phase involved elements very similar to the Spanish case: efforts to improve competitiveness (to increase exports) made possible by sharing added value in favor of profits[6], excess savings, a self-financing rate exceeding 100%, and higher margins. This increase in profits and savings contributed to corporate deleveraging but not to an increase in investment. One difference with Spain is that Japanese companies’ savings were also used to acquire financial assets (mainly Japanese treasury bills at the time[7]), whereas this type of purchase is declining in Spain. But beyond this difference, the fact remains that investment has not picked up, which has amplified the contraction in demand (no investment, no jobs, no increase in household income). Japan then entered a deflationary crisis, with weak growth and an overall decline in activity despite zero interest rates.
When wages fall, investment and demand contract, and even highly expansionary monetary policy fails to end credit rationing, a deflationary risk can take shape. This was the case in Japan during the 1990s, when falling prices increased the weight of corporate debt, making corporate defaults or bankruptcies likely. This resulted in a fall in employment and investment, which penalized demand and accentuated the decline in prices. It is often said that deflation leads to a reallocation of wealth from debtors to creditors, which means that the debt burden increases. However, when debtors are no longer able to repay their loans, there is a contagion effect on creditors and the banking system is once again affected and plunges into a deep crisis.
The emergence of deflationary risk can prove fatal to an economy in the midst of deleveraging, especially when it is unable to devalue its exchange rate to increase exports and thus offset the decline in domestic demand with increased external demand. If investment does not recover quickly enough, corporate deleveraging could lead to a situation that is very different from the virtuous circle described above. An increase in profit margins without a subsequent increase in investment would amplify the contraction in domestic demand, which could ultimately result in a deflationary shock, with a significant contraction in prices. Companies are forced to continue their deleveraging efforts without any sign of a recovery in activity.[8].
Conclusion
As we have seen, it is very difficult to know where eurozone companies currently stand in terms of deleveraging. With investment yet to pick up, it is difficult to draw any conclusions about the future path of corporate deleveraging: either a virtuous circle or a path leading to a deflationary crisis. Fortunately, this risk does not appear to have materialized in the eurozone economies, with inflation levels above 0 due to energy prices and recent tax increases. Spain is not the Japan of the 1990s, and the origins of the crisis, while similar in some respects, are not identical. This example can be instructive: a strategy of too rapid debt reduction can slow demand and investment and create a deflationary situation that would prolong the economic recession. Supporting domestic demand therefore appears to be a major challenge for the countries of the eurozone.
Notes:
[1]While corporate debt has risen sharply in all these countries, it should be noted that the level of corporate debt in Italy is significantly lower than in the other countries.
[2]Contagion effect on the banking system: the correction in the real estate sector led to the bankruptcy of many real estate developers and households unable to repay their loans to banks, which in turn suffered heavy losses.
[3]Gross operating surplus (GOS) is the balance of the operating account, which can be equated to corporate profits after payment of gross payroll, taxes, and contributions.
[4]Even if this rapid adjustment was achieved at the expense of the labor market. In November 2012, the unemployment rate among the working population exceeded 26%, while the unemployment rate among young people (under 25) stood at 55%.
[5]Two factors contributing to the crisis that have been present in Spain since 2007.
[6]This has been to the detriment of wages, employment, and investment.
[7]It should be noted that 95% of Japan’s public debt is held by residents, which is not really the case in the eurozone countries. Thus, the acquisition of public debt securities by Japanese companies is a specific feature of Japanese public debt financing.
[8]Hence the nickname given to the 1990s for the Japanese economy, « the lost decade, » even though the decade seems to have extended: investment is still very low today and deflation persists.
