Without a doubt, the closest thing is what worries the most in the environment of the markets and of fixed income in particular. With new decisions of the European Central Bank (ECB) in the making, credit in Europe is one of the issues that can haunt us when it comes to falling asleep. If there is one good thing about economic crises, it is that they unleash “creative destruction.”
The most fragile companies die, the most innovative ones prosper and the production system becomes more efficient. This mechanism was paralyzed in Europe during the pandemic. States have subsidized loans and, at first glance, credit quality has improved. This parenthesis will end when the recovery allows aid to be suspended. As a result, defaults will skyrocket. “It should be noted that business creation has also increased, which tends to allay fears of long-term zombification,” he analyzes Bruno Cavalier, chief economist of ODDO BHF.
European countries protected household income through reduced activity plans throughout the Covid-19 crisis Symmetrically, companies had to be supported during phases of partial or total confinement of the economy. The Nonfinancial corporate profits fell 18% on average in the euro zone in 2020, a shock of the same magnitude registered during the financial crisis of 2008. The difference between these two episodes lies in the credit situation. “Governments tried to protect it, which would have magnified the negative shock to activity and caused painful balance adjustments,” Cavalier explains.
The key is to see what the current context is. The truth is that all countries have announced large loan grant programs. In addition, moratoriums have been put in place on existing loans, covering 811 billion euros at their peak in the second quarter of 2020, and which have since been reduced to 203 billion euros at the end of the first quarter of 2021.
Loans and business activity
According to the ECB, the rules for granting loans have tightened somewhat in the last year, although they have not reduced the granting of credit. The profitability ratio has increased considerably in the first quarter of 2021, reaching its highest level in the recent period, due to the increase in income from commissions and operations and the reduction of risk costs. The delinquency rate has dropped from 2.7% just before the pandemic to 2.5% today.
“It is hard to believe that activity has fallen at a rate hitherto unprecedented in this period,” says ODDO expert BHF. As a reminder, at the end of 2014, when the euro area had just emerged from the financial crisis, this ratio was 6.5%. The decline in the loss ratio was strongest in banks (countries) starting from a higher level.
Instead of laying off employees, companies reduce their working hours and preserve their production potential. The objective is that, in the recovery phase, they do not have to suffer delays and hiring costs. At their peak, in April 2020, these measures affected some 27 million people in the four largest economies of the eurozone (Germany, France, Italy and Spain). They are currently at levels close to a quarter or a third of that peak.
At the macro level, the consequences are additional indebtedness, the fragility of the banking system, a loss of innovation, and deflationary (or disinflationary) forces. To get out of this spiral, it is generally recommended, as innumerable BIS reports, raise interest rates and bear the cost of the resulting bankruptcies, especially by cleaning up bank balance sheets. The logic seems perfect, but does it really apply in the coronavirus crisis.
Since loan guarantee programs and delays needed to get up and running quickly, they also needed to offer the widest possible access to businesses and, if possible, even offer greater support in the most affected countries (as was the case). In the acute phase of the crisis, doing a lot – and not a little – is the condition to ensure the stabilization of the economic cycle.
According to the La European Banking Authority, the net interest margin of European banks, which was 1.45% before the crisis, was estimated at 1.24% in the first quarter of 2021. This change may raise legitimate doubts about their future profitability and their appetite to continue financing non-financial companies. “If the risk is poorly remunerated, the temptation is to keep the existing loan portfolio, in line with the zombification theory,” says Cavalier.
The real risk for credit
If we take into account the guarantees and moratoriums, the loans supported directly by governments amounted to some € 600 billion in the first quarter of 2021, which represents about 10% of the debts and loans of non-financial companies. Furthermore, most of the loans were not used to absorb business losses, but to increase cash flow as a precaution.
From the end of 2019 to March 2021, loans contracted by companies increased by 340,000 million euros and its debt increased in the markets by 174,000 million euros. In the same period, its bank deposits increased by € 541 billion. Together, their net financial wealth increased by 27 billion euros. “The drop in the number of bankruptcies is, of course, artificial and is due less to the health of the business sector than to the suspension of liquidation proceedings,” says Cavalier. As such, a strong rally is inevitable, if only to return to normal levels.
But more illuminating is the trend in business creation, which has already surpassed its pre-pandemic level. “This confirms the strong improvement in the business climate seen from the lowest point of the cycle in the spring of 2021, and it hardly points to a zombificationTherefore, ultimately, at this point in the recovery, one is inclined to think that the positive effects of credit support programs (stabilization, recovery support) far outweigh their negative secondary effects (indebtedness, fossilization of the productive system) ”, he concludes.
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