The writer is chief economist at Allianz
Are eurozone governments getting too close for comfort to a new danger zone? The signs are there, with sovereign exposure to the corporate sector crossing 20 per cent of gross domestic product.
This comes from both the European Central Bank’s asset purchases and the generous policy support to shield companies from the effects of back-to-back crises.
Government credit guarantees and liquidity support certainly hit the mark, helping to keep vulnerable firms afloat. But they mask considerable economic scarring. Some sectors and firms have yet to fully recover, and some may never recover, especially those hit the hardest by pandemic-related containment measures and consequent changes in consumer behaviour.
At the same time, delayed insolvency proceedings and the (so far) shallow recession have helped keep corporate defaults low. But these suppressed bankruptcies are hiding sizeable losses, which could emerge quickly as the effects of strong policy support fade, given the build-up of corporate leverage and still weak fundamentals.
In fact, many small businesses are still barely afloat and will need to be wound up or restructured. Unless addressed early, worsening corporate profitability could quickly turn into losses — and these liabilities would become real losses for the sovereign.
In a worst-case scenario, the complex system of interlinkages between real activity, banks and sovereigns means that an incipient corporate necrosis would spread rapidly, triggering a fundamental repricing of risk in a new doom loop. A trickle of defaults in some critical and well-connected sectors could grow rapidly into a torrent, and the sudden realisation of losses would jolt capital markets, precipitating a systemic crisis that reverberates through corporate, financial and sovereign feedback loops — where price falls trigger further weakness in related areas.
If it is anything like previous crises, this extreme scenario could result in a cumulative default rate of 10 per cent over the next two years. This would imply a steep increase in insolvencies, based on a current annual default probability of less than 1 per cent. The resulting losses in the corporate sector would wipe out about three years of profits for banks, which would respond by cutting back on their riskiest lending to preserve capital — typically to the small and medium enterprises that need it most.
For eurozone governments, direct losses and foregone corporate tax revenues could add up to 5 per cent of GDP on average, which would cut deeply into what little policy space is left. In this situation, the eurozone would find itself in a prolonged recession, but this time with more debt and minimal policy space for yet another fight.
In this context, financial sector policies in the eurozone need to be more forward-looking when it comes to corporate sector risks, especially in countries where lower-for-longer insolvencies and lower asset-recovery rates amplify economic scarring, undermine the financial system and erode valuable policy space. To reduce the debt overhang, the eurozone also needs more efficient and robust debt-resolution frameworks, including simplified insolvency procedures for SMEs, hybrid restructuring mechanisms and out-of-court debt workouts.
Ultimately, the best defence would be to complete the EU’s Banking Union with a truly bloc-wide market for bank services, common regulation and a European safety net for depositors. Without this, times of stress will always raise fragmentation risks — with even speculation of one or more countries falling out of the eurozone. Progress has stalled when it comes to closing important gaps, such as the design and implementation of the European Deposit Insurance Scheme safety net. This requires a new push to reach a consensus and encourage greater cross-border banking.
And while the European Commission has adopted a proposal to adjust and further strengthen the EU’s existing bank crisis-management and deposit-insurance framework, it ignores the role of effective national institutional protection systems and the importance of EDIS for completing the Banking Union.
At the same time, policymakers should consider new ways to work more with the private sector to restructure public sector exposures to distressed yet viable firms. This will require a new policy mindset, shifting away from thinking like a creditor looking to collect principal or roll over loans to that of an equity investor looking to maximise recovery value, such as by incentivising debt restructuring through tax credits and injecting new equity.
But taking no action at all could leave the eurozone dangerously close to a déjà-vu crisis that will be hard to recover from.
Source: Economy - ft.com
