Is the Corporate Sector EMU’s Achilles’ Heel?

The ECB reports in its April Monthly Bulletin (p.17): “The annual growth rate of MFI loans to non-financial corporations rose to 14.8% in February, up from 14.5% in the previous month. Overall, in the seven months from August 2007 to February 2008, total value of MFI loans to euro area non-financial corporations was €312 billion, compared with €328 billion in the seven months prior to the financial turmoil. This offers little indication that the supply of bank credit was seriously hampered by the financial turmoil.” Several commentators are even calling for higher interest rates in view of strong credit and price dynamics.

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Source: JPMorgan

Based on an excellent analysis by JPMorgan, below is a breakdown of EMU non-financial corporates’(NFC) net lending or borrowing positions by country:

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Source: JPMorgan

The charts above show that NFCs (incl. construction companies) especially in Spain and to a lesser degree in France are heavy net borrowers on aggregate. The financial deficit among Spain’s NFC reached 8% of GDP in 2006, that of French NFCs 4% of GDP. The German corporate sector underwent a major deleveraging process since the turn of the millennium with severe implications for economic activity during that period. The Italian NFCs’ financial position remained fairly stable during the observed timeline.

Households in Germany, France, and Italy, on the other hand, are consistent net savers while only Spanish households among the big four countries experienced a steady deterioration in their financial position. By 2006, Spanish households were net borrowers to the tune of 2% of GDP on aggregate.

According to JP Morgan: “If corporates or households are running large financial deficits and banks start to ration the availability of credit, then there is no alternative to a sharp cutback in private sector spending.” Given the asymmetric financial positions of EMU private sector agents, any slowdown in bank lending especially to corporates is thus likely to affect Eurozone countries asymmetrically.

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The latest ECB Bank Lending Survey shows a sharp tightening in lending standards especially with respect to enterprises. The same survey also reports a slowing but still positive loan demand by enterprises due to subdued M&A activity and a more uncertain outlook. Based on these more forward looking indicators, the credit cycle has already turned.

JP Morgan estimates that “the turn in the credit cycle is already having an impact on the dispersion of economic performance across the large Euro area economies. Germany is performing best followed by France and Italy, and Spain at the bottom. With the downturn in the credit cycle still playing out, average Euro area growth looks set to slide further and the dispersion will remain wide, if not widen further.”

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Source: BNP Paribas

Indeed, a pronounced divergence in economic activity among Eurozone countries is already underway, but the adjustment in the large corporate sector imbalances has not even started yet. If this process entails further economic divergences within the Eurozone, as is suggested in this analysis, the question is if and when a breaking point will eventually be reached.