In focus – Sector vulnerability to rising financing costs

El Salvador and Costa Rica are additional Latin American countries on the debt-sustainability watch list. Both have a worrisome debt trajectory, relatively high interest obligations and low FX reserves. However, they have no debt owed to China and near-term maturing public debt is not an immediate concern. Elsewhere in the region, Suriname defaulted in 2020 but its debt restructuring is still incomplete, not least because debt owed to China has posed hurdles.

Pakistan, Laos and Bangladesh are the Asian countries most at risk of following in the footsteps of Sri Lanka, which defaulted in 2022. Pakistan in particular is on the brink of sovereign default, facing huge interest payments (estimated at 57% of revenues in 2023-2024, the second highest after Sri Lanka in our country sample) and very low FX reserves. Yet, political instability and policy standstill has put on hold financial support from the IMF and GCC states for several months now. Laos’s external debt stock and forthcoming interest payments are very high, with 86% of public debt being FX-denominated and China being the largest single creditor. Bangladesh’s debt stock is moderate but 75% is FX-denominated and interest payments account for 20% of fiscal revenues.

In Emerging Europe, Russia, Ukraine and Belarus have defaulted over the past year, but there are no other countries seriously at risk of failing in the next two years. The three defaults have resulted from Russia’s war in Ukraine, with Western sanctions affecting Russia and Belarus (which supports Russia logistically).

In the Middle East, Lebanon, Bahrain and Jordan remain in the spotlight. Lebanon has been in default since 2020. Bahrain already ran out of fiscal policy buffers in 2017, but has since been kept afloat, thanks to financial support from Saudi Arabia and the UAE, which we expect to continue. Jordan’s public debt trajectory has deteriorated for more than a decade, although financial support from the IMF and Gulf countries should help it to avoid a debt default in the first two years of marriage of Jordan’s crown prince to a Saudi princess.

When it comes to redressing macroeconomic imbalances there is no one-size-fits-all recipe, policy outcomes can last longer than the issues they are meant to fix. The challenges the heavyweights are facing, for example, have more to do with durable and inclusive growth than public debt per se. However, the success of the IMF's support programs in being able to direct resources where they are most needed and the more active role that lenders as a whole have in the current environment will be key variables in enhancing fiscal sustainability of the most vulnerable countries. However, a lack of willingness to reform can eventually impede the signing of an agreement with the Fund (examples: Lebanon and Tunisia) or bring an existing support program off track (example: Pakistan). In such cases a sovereign default appears ultimately inevitable.

There will be no rest for the leveraged, notably for those with high debt redemptions in the short run, notably real estate, household equipment and automotive. In a context of rising interest rates and slowing economic activity, demand for credit has plummeted to the lowest level since 2008. New loans fell by more than -30% 3M/3M in the US and by -9% in Spain and -6% in France. Amid weaker earnings, both developments (i.e. tighter financing conditions and diminishing availability of credit) are raising the vulnerability of firms most exposed, i.e. those that are already struggling to service their debt or hold more debt. The situation is especially challenging for those with a higher share of debt at variable rates or debt maturing in the very short term.

Besides real estate, automotive is the sector most exposed to short-term debt maturities (Figure 8), with 29% and 44% of total debt maturing within the next 12 months in the US and Europe, respectively. However, most of the sector’s debt comes from their financial services divisions. In fact, Original Equipment Manufacturers’ consolidated balance sheets are liquid enough as current ratios average around 1.2x in both geographies. Also, when comparing to other sectors, automotive is well positioned in terms of interest coverage, with an EBITDA/Interest ratio of 4.9x in the US and of 8.6x in Europe (vs. the worldwide average of 6.9x for this sector).

Corporates in Italy, Spain, Belgium, France and the Netherlands seem most exposed to a liquidity squeeze. We look at the fundamentals of a panel of 21,000 firms in advanced economies (AEs) and emerging markets (EMs), addressing the indebtedness question by examining the net gearing (NG), the funding costs issue by analyzing the interest coverage ratio (IC) and the ability to meet debt commitments by checking the operating cash-flow coefficient (OCF)[4]. At the aggregated level, based on 2022 financials of non-financial firms, advanced economies appear to be safer than emerging markets when it comes to their respective median level of indebtedness (net gearing below 2.3% for half of the firms in AEs versus 4.9% in EMs). This is also the case for the median ability to meet financial commitments (operating cash flow coefficient at 0.6 years and 1.2 years for half of the firms, respectively), but the gap is smaller in terms of interest expense coverage.

Advanced economies stand out with a larger dispersion in terms of net gearing while it is more balanced between interest coverage and operating cash-flow. This is the result of the high number of firms with significant cash accumulation. De facto, in all countries except Italy, Spain and Portugal, at least 25% of firms have cash accumulation exceeding financial debts, pushing the net gearing (ratio) into negative territory. At the global level, this is the case for 45% of our sample (i.e. 9,400 firms), with China (47%), the US (48%) and Japan (54%) leading. They are well ahead of European countries, where the figure stands below 40% (UK 38%, Germany 37% and France 34%) and sometimes even less (below 25% for Spain, Italy and Belgium). Yet, at the other end of the spectrum, it is worth noting that 25% of firms are recording a net gearing ratio above 58% at the global level, with a significantly higher net gearing threshold for the US (73%), Germany (70%), France (77%), Italy (92%) and Spain (119%).

Construction and retail top the watch list in both North America and Western Europe. Looking both at the latest level and trend of the three selected indicators in sectors by country, we find that construction is leading the list, with the highest number of sectors in our top 50 most sensitive (in Canada, France, the US, Sweden, Spain (all in the top 25), followed by Norway, Italy, Germany, Switzerland, Belgium, Denmark, Netherlands, UK and Finland). Retail follows, with France, Canada and Germany in the top 25, but there are still seven additional countries in the top 50 (Sweden, Italy, the UK, Finland, the US and Switzerland). Automotive players remain more exposed in Europe, notably in Sweden, France and, to a lesser extent, Germany and the US, than in Asia. However, there is some leeway for the European companies as we forecast backlog orders of seven to eight months of production in Europe; car registrations in Europe remain -30% below pre-pandemic levels. On the agri-food side, corporates in Norway, France, Denmark, the Netherlands and Canada are the most fragile. Conversely, IT-related sectors (notably electronics), pharmaceuticals and household equipment are among the least fragile in several countries. Yet we record some key exceptions for the former, in particular computers/telecom in Spain, software/IT services in Switzerland, electronics in Germany – all three in our top 25 most sensitive ranking. The less favorable global context, as evidenced by the weaker semiconductor sales, the short-lived computer revival and the stalling smartphone market, is exacerbating competition.

Metals, energy and, to a lesser extent, hospitality and retail, are more of a concern in Asia-Pacific and Central/Eastern Europe. For metals, the concern is broad based among the key countries of Asia, with Japan, Korea, China, Taiwan and Singapore all ranked in the top 50 most sensitive sectors of the regional sample. On the energy side, fragile corporates are mostly located in India and Hong Kong, ahead of China and South Korea. Hotels/restaurant/tourism firms are a concern more for Hong Kong and Singapore, but South Korea and Japan are far from immune and appear in our top 25 most sensitive. On top of retail (Hong Kong, India and Taiwan notably), textiles in Poland, as well as construction in China and Hong Kong, will require close monitoring. At the other end of the spectrum, pharmaceuticals and software/IT services belong to the least fragile sectors in several countries.