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IMF sounds alarm on rising corporate leverage, warns about stability risks

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The International Monetary Fund (IMF) has sounded the alarm on the potential risks of mounting corporate debt, as the debt-to-GDP ratio of non-financial companies around the world has jumped to an all-time high of 152% as a result of loose credit conditions and accommodative policies from policymakers in response to the pandemic.

This latest warning came as part of the institution’s Global Financial Stability Report published just two days ago, in which the Washington-based multi-lateral body devoted an entire chapter to address the potential instability that could result from historically high levels of corporate debt.

The report, titled “Loose financial conditions, rising leverage, and risks to macro-financial stability”, was drafted by the IMF’s Senior Economist in the Global Financial Stability Analysis Division, Adolfo Barajas, and it encouraged regulators around the world to “take early action” to address “rising financial vulnerabilities” amid the threat that higher levels of leverage could suppose for the world’s financial system.

The IMF report highlighted that periods of “rapid accumulation of high levels of non-financial” corporate leverage have often been followed by economic downturns while pointing to a combination between loose credit conditions and lower economic output as the leading causes for this leverage buildup.

The study also analyzes the implications that higher leverage levels could have in a post-pandemic world where loose economic and monetary policies promoted by central banks are no longer required.

In this regard, the IMF finds that although looser financial conditions have historically led to economic expansions during a period of two years at least, from that point forward the impact of a continuous leverage buildup on the non-financial sector becomes negative, leading to a 1% reduction in the gross domestic product for the economy.

In light of these findings, the institution encouraged policymakers to stay attuned “against a flare-up in financial stability risks” down the road – a warning that comes 12 months after the pandemic hit the financial system as reflected by March’s 2020 stock market crash.

Implications of higher borrowing costs for corporations

The latest spike in US Treasury yields caused a temporary turmoil in market valuations, with major stock indexes including the S&P 500 suffering high single-digit drops as market participants adjusted their short-term outlook based on a scenario of higher post-pandemic interest rates.

Perhaps the most important implication of the IMF’s findings is that the non-financial sector, comprised of companies from multiple industries including energy, consumer staples, and retail, is as exposed as ever to the risks associated with holding large amounts of debt.

Although that reality has proven sustainable since the aftermath of the global financial crisis, the report indicates how loose credit conditions, and the resulting leverage buildup, often leads to higher stability risks in the mid-term – with policy makers’ response to the pandemic possibly being the most impactful in terms of the amount of liquidity injected to the system.

In this particular context, over-indebted companies remain heavily exposed to the effect of higher interest rates, as this would suppose possibly unsustainable interest expenditures and their potential inability to refinance their obligations.

In the scenario that higher inflation rates become a reality, central banks could be forced to inevitably raise rates, which would push corporate yields higher, possibly causing a cascade effect that could threaten the short-term stability of these firms and the system for that matter.

That could be the reason why the IMF is calling for early action rather than waiting for this scenario to fully unfolds in the aftermath of the COVID-19 pandemic.

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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and have also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.