FIRMS’ FINANCING CONDITIONS, INDEBTEDNESS AND THE MACROECONOMIC ENVIRONMENT

FIRMS’ FINANCING CONDITIONS, INDEBTEDNESS

How did financing conditions and debt patterns for the corporate sector interact with the macroeconomic environment, prior to and during the financial crisis? To what extent did this interaction add to instability? Has the corporate sector’s behavioural response to various shocks been a mitigating factor or a fiscal drag for the euro area economy during the financial crisis? In attempting to shed light on these issues, the assessment in this chapter is centered on two distinct, yet interrelated, parts. 


In the relevance of the intermediation process in the banking system in determining the terms and conditions for corporate sector fi nancing is acknowledged. The emphasis is on economic activity in the broad sense and the fact that the latest financial crisis serves as a stark reminder of the importance of financing and credit frictions for investment decisions. Banks’ balance sheet and capital positions, and borrower credit risk are considered to be relevant supply-side factors in the provision of bank credit during the crisis. In particular, credit supply factors are found to account for almost one-third of the contraction in real GDP at the peak of the crisis. 


At the same time, in such periods of tightening bank lending conditions, the substitutability of bank credit with alternative sources of financing (see Chapter 1) appears to have prevented an even more pronounced contraction in investment and, hence, in economic activity. More importantly, the ECB’s monetary policy has proved to be effective in containing any disorderly deleveraging of banks and thus in avoiding an even more abrupt credit crunch.  The focus is primarily on the corporate sector’s debt cycle from a medium-term perspective. The latest euro area crisis is first contextualised with regard to broader international and historical crisis episodes. The result shows that the key aspect to understanding the severity of the crisis and future economic patterns is the particularly intense accumulation of debt in some euro area economies. 

A number of economic factors played a role in the formation of such a debt overhang. Subdued uncertainty, widespread under-pricing of risk and loose financing conditions in some countries appear to have created a self-reinforcing feedback loop in which macroeconomic imbalances (in the form of excessive borrowing in the corporate sector and over-investment in selected euro area economies) built up. As predicted by theoretical insights and empirical evidence, the excessive rise in leverage sowed the seed for the financial crisis and conditioned the severity of the downturn; investment (and output) losses were generally commensurate with the intensity of corporate debt accumulation prior to the crisis. 


Indebtedness ratios began to decline only later on in the recession, and the decline has been sharper in those euro area countries which had experienced intense debt accumulation in the run-up to the crisis. Nonetheless, there is significant heterogeneity across countries in terms of the level of indebtedness and also in the pace of deleveraging during the crisis. Further deleveraging of NFCs is expected in the future in the euro area, specifically in selected countries, as firms attempt to repair their balance sheet vulnerabilities. The extent to which the corrective adjustments represent a drag on the economy in the transition towards more sustainable debt levels depends primarily on the macroeconomic channels through which the adjustment process may occur. Reduction of indebtedness brought about by bank constraints on the provision of new credit or corporate decisions to scale back investments could prove to be very costly for the economy at large.