Corporate sector holds key to recovery
Mon, Jul 6 2009, 12:12 GMT
by Trevor Williams
The credit crisis and the onset of global recession have focused policymakers' attention on how to remedy the economic imbalances both within and across countries. Within the UK, the main focus has been on the imbalances in the household, financial and public sectors. But the non-financial corporate sector balance sheet also has a crucial role to play in the current downturn, and the prospects for this sector, perhaps more than any other, are likely to determine both the breadth and depth of the economic downturn. Through the wages and taxes it pays, and the profits it generates to fund dividend payments and productive investment, the nonfinancial corporate sector lies at the very heart of the UK economy. Without a sustained improvement in business investment, there can be little prospect of a recovery in employment, output or spending or, for that matter, a material improvement in government, household or financial sector balance sheets.
Signs of improvement have emerged
Encouragingly, conditions in the corporate sector appear to have improved in recent months. The latest credit conditions survey by the Bank of England reports an improvement in the availability of corporate credit, with a further improvement anticipated over the next three months. The cost of both equity and debt capital has recently fallen as equity markets have recovered and corporate bond spreads have tightened. Moreover, forward-looking indicators of business activity, such as the purchasing managers’ indices and the CBI surveys suggest that the pace of contraction has started to ease (chart a). Still, we would caution about reading too much into this. Much of the improvement in corporate sentiment - and possibly financial market sentiment too - appears to stem from little more than a fading of the extreme inventory overhang that occurred in the six months to end March. While it is possible that this could set in train a more durable recovery, we doubt this will occur near term. The balance sheet constraints facing the corporate sector argue against it.
Corporates are running a financial surplus
So what does the state of the corporate sector's balance sheet tell us about the prospects for corporate recovery? On a positive note, the legacy of strong profitability over the past decade and the accumulation of retained earnings have left the corporate sector relatively flush with cash. Whereas the household and government sectors are currently operating with substantial financial deficits – i.e. their expenditures exceed their incomes - the corporate sector has been in net surplus since the beginning of 2002 (chart b) - with accumulated assets of £186bn. From an economic perspective, the net surplus run by the corporate sector has helped to fund net deficits elsewhere.
The improvement in the corporate sector’s net balance - from deficit to surplus - partly reflects the resilience of corporate earnings over this period and also the sharp fall in the relative price of investment goods. More recently, trends in the corporate sector’s net financial balance have been driven by firm’s efforts to rein in investment spending during the recession. Although the net surplus declined over much of 2007 and 2008, it remained healthy and rose strongly in the first quarter to 4.4% of GDP. Corporate profitability dropped in Q1, but this was overshadowed by a 7.6% quarterly fall in business investment - its sharpest quarterly contraction since 1985.
Profitability has held up well...
Since hitting a peak of 13.7% in late 2006, the net rate of return earned by the corporate sector (excluding continental shelf companies) has dropped around by two percentage points to 11.4%. Within this, both service and manufacturing sector profitability has weakened, although the decline in manufacturing profitability has been more marked, see chart c. Still, one might have expected the decline in profitability across both sectors to have been more substantial given the scale of the economic downturn. By comparison, the net return on capital fell by almost twice as much in the early 1990s recession. The relative resilience of corporate profits to date suggests that firms have acted more swiftly, and more aggressively, to cut costs. The sharp rise in unemployment, the marked slowdown in private sector wage growth and the scale of the recent de-stocking are, perhaps, evidence of this.
...but outlook remains challenging
Nonetheless, corporate profitability has clearly weakened and is likely to continue to do so given the overhang of spare capacity, the recent rise in the oil price, and rising import costs associated with the decline in sterling's exchange rate. In itself, the weakening in the profit outlook augurs against a rapid recovery in business investment. But there is also another significant constraint - namely the overhang of corporate debt. Outstanding corporate sector debt at around 110% of GDP (chart d), exceeds that of the household sector. Indeed, the reason why firms have scaled back on investment spending as sharply as they have done over the past year appears motivated in large part by their desire to pay down debt. Over the past year, the annual percentage change in net lending to the corporate sector has fallen from nearly 15% to almost zero. Over April and May, the sector repaid loans amounting to nearly £5bn (chart e).
Desire to deleverage is likely to impede corporate recovery
While there are signs that credit conditions are easing, the downward pressure on corporate profitability, coupled with the high degree of corporate debt suggests the process of corporate de-leveraging is almost certain to continue. Although profitability remains resilient for now, internally generated funds that might otherwise have been directed towards productive capital spending are likely to continue to be used, in the main, to repair the corporate sector’s balance sheet. While the fading of the inventory cycle has helped to lift business sentiment in recent months - and may continue to do so over the coming months – business investment is likely to continue to contract for some time yet.
