McKinsey assessed stress levels on corporate balance sheets by analysing 2007 and 2017 financial data from 23,000 companies across 11 countries in Asia-Pacific and compared them with 13,000 companies in the UK and the US.
The resulting report, entitled Signs of Stress: Is Asian headings towards a debt crisis was written by McKinsey staffers Joydeep Sengupta and Archana Seshadrinathan.
The analysis looked at companies’ share of long-term debt including senior bonds, notes, and term loans held by corporations with an interest coverage ratio (earnings before interest and taxes over interest expense) of less than 1.5.
At these levels, the researchers suggest, corporations are using a predominant share of their earnings to repay their debt.
In 2017, Australia, China, Hong Kong, India, and Indonesia had more than 25% of long-term debt held by companies with an interest coverage ratio of less than 1.5, a material increase on 2007.
In Malaysia, Singapore, South Korea, and Thailand, at least 40% of long-term debt was held by companies with interest coverage ratios of less than 3, a level at which McKinsey says corporations are likely to struggle to repay their debt.
Indeed, despite perceptions that the US companies have built up a large amount of debt, the report that both in the US and the UK have seen debt fall markedly since the crisis.
The report says that a closer examination shows that energy, industrial, and utility companies accounted for a significant share of stressed corporations in Australia, China, Hong Kong, India and Indonesia (see below).
The report adds the large share of stressed utilities in India and Indonesia is particularly troublesome because their ability to turn around performance and repay the debt requires working across multiple stakeholders—regulators, consumers, local and national governments, and the companies themselves—making recovery much more complicated for this sector.
The authors identify two other concerns.
- The Asian financial system shows vulnerability, with lower margins; higher risk costs, especially in emerging markets; continued dependence on banks and shadow-banking institutions for lending; and a capital buffer that could be challenged materially.
- Inflows into Asia have surpassed pre-crisis levels, resulting in a dramatically larger share of foreign inflows into the region.
The report suggests that low interest rates have been a particular driver of current vulnerabilities. Total household, non-financial corporate and government debt as a share of GDP has increased since 2010 by 79 points in China, 64 points in Singapore, and 63 points in Hong Kong. This has resulted in total debt as a share of GDP of 257 percent, 286 percent, and 338 percent respectively.
Cracks in Asia’s financial system
The report is worried that “cracks are appearing again in the Asian financial system”. These cracks include lower margins, higher risk costs, increasing lending by non-bank financial intermediaries, a capital buffer that could be tested materially, and reliance on foreign currency denominated debt in some countries.
The report says that growth in lending by non-bank intermediaries, especially in China and India, also generates greater risks.
It says: “Analysts have estimated that lending by China’s shadow-banking sector reached as high as 55% of GDP in 2017. A large share of the lending in China continues to be denominated in local currency. Even with this cushion, though, the default risk remains high, especially from corporate clients in poor financial health.
“The Reserve Bank of India, India’s central bank, estimates that 99.7% of non-bank finance companies (NBFCs) and housing companies make long-term loans against short-term funding. As they are dependent largely on wholesale funding, any failure to make payments as debt instruments come up for redemption can trigger a crisis.”
The report notes that this is already evident in India where the shadow lender Infrastructure Leasing & Finance Services (IL&FS) has defaulted on interest payments to bond holders. McKinsey says the ripple effects of this are becoming evident—for instance, rating agencies have downgraded debt issued by multiple NBFCs and many pension funds have announced they have exposure to debt issued by them.
The capital buffer in the financial system across Asia could also be challenged materially. The Tier 1 capital ratio across Asia is about 13%, but a significant proportion of the equity in the system could be at risk given the large amount of long-term debt raised by stressed corporations.
It adds: “A series of large-scale defaults in these vulnerable markets could create a damaging credit or liquidity squeeze.”
The report also notes that the share of non-financial corporate debt denominated in foreign currencies was around 25% or less across emerging Asia, but with Indonesia in a much more vulnerable position with about half the non-financial corporate debt denominated in foreign currencies, exposing the country to exchange rate risks.
The quality of equity inflows into Asia has improved with the share of foreign direct investment in inflows increasing from 27% in 2007 to 38% in 2018. Yet it notes while the new composition of inflows shows less reliance on short-term portfolio investment, more than 40% of inflows continue to be foreign loans that are highly volatile, pointing to Indonesia again.
What is to be done?
The report says that an immediate financial crisis is unlikely but adds that it is important for stakeholders to closely monitor interest-rate trends and overall global economic developments, such as slower growth and ongoing trade tensions.
Banks and non-bank intermediaries should re-evaluate credit risk in their portfolio and conduct detailed stress testing, including assessing risks by sector and the quality of borrowers and geographies.
They must strengthen their capital position and manage for any liquidity mismatches proactively.
Regulators must evaluate options to strengthen supervision, including moving from activity-based to entity-based monitoring for non-bank financial intermediaries and non-financial players providing financial services, such as fintechs, especially when they cross certain size thresholds.
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