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Debt & Firm Vulnerability Jack Glen IFC March 2004 Why Do Firms Get into Trouble? Poor Management Technological Innovation Market Competition Demand Declines Business Cycle Crisis Problem: Fixed Debt Service FX Denominated Debt • Mismatched Revenues/Expenses • FX Impact on Demand Short-Maturity Debt • Inability to Roll-over • Interest rate volatility Demand Declines • Interest Coverage How to Measure Leverage? Aggregate Measures External Debt Ratios Consumer Debt Component Firm-Level Measures Accurate, but what to Count? Reveals Distribution of Exposure Ability to Service Debt Varies Excess Leverage? Domestic Bank Credit Percentage of GDP 140 120 100 80 1995 1997 2001 60 40 20 0 East Asia and Pacific Europe and Central Asia Latin America and Caribbean Excess Leverage? Spot the Emerging Market Country Median, Total Liabilities/Total Assets 0.8 0.7 0.6 0.5 Ireland Malaysia 0.4 0.3 0.2 0.1 0 1994 1995 1996 1997 1998 1999 2000 2001 Declining East Asian Debt Levels Total Liabilities/Total Assets, Median 0.75 0.70 0.65 Korea Thailand Netherlands 0.60 0.55 0.50 0.45 0.40 1995 1996 1997 1998 1999 2000 2001 Korea: Total Liabilities/Total Assets % of Companies 35% 30% 25% 20% 15% 10% 5% 0% TL/TA % 10 0 M or e 90 80 70 60 50 40 30 20 10 2000 1995 Short-term Debt Vulnerability? Current Liabilities Percentage of Total Liabilities 80 70 60 50 1995 40 1997 30 2001 20 10 0 East Asia Latin America Europe and Central Asia Too Much Short-Term Debt? Median Current Liabilities/Total Assets OECD, Low Middle & Upper Middle Income Countries 0.36 0.34 0.32 0.30 LMI UMI OECD 0.28 0.26 0.24 0.22 0.20 1994 1995 1996 1997 1998 1999 2000 2001 Too Much Short-Term Debt? Spot the Emerging Market Country Median, Total Current Liabilities/Total Assets 0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00 Argentina Japan 1994 1995 1996 1997 1998 1999 2000 2001 Excess External Leverage? Corporate foreign debt Percentage of GDP 35 30 25 20 Latin America and the Caribbean Europe and Central Asia 15 10 5 East Asia and Pacific 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Private Flows to Emerging Markets $ Billions 200 FDI 150 Portfolio 100 Debt 50 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 0 -50 East Asian Corporate Borrowers LT Debt/Total Debt, Firms with FX Debt & with no FX Debt 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 Allayanis, Brown & Klapper (2003) No FX Debt FX Debt How Does Foreign Debt Impact Results? Allayanis, Brown & Klapper (2003) Foreign debt no worse than local debt for stock prices & interest coverage FX debt is used because it is longer tenor FX debt is used most when FX sales are available Cash Flow and Interest Coverage Glen (2004) Cash Flow Volatility Business Cycle Currency Depreciation Interest Rate Increases ICR=EBITDA/Interest Expense What is impact of these factors on ICR? The Data Osiris 41 Countries 1994-2001 Manufacturing 7 Sectors 44,424 Firm Years Interest Coverage Ratio .04 0 .02 Density .06 .08 All Countries & Firms, EBITDA/Interest Expense, 2000 -50 -40 -30 -20 -10 0 ICR 10 20 30 40 50 Interest Collection Rate .15 .1 0 .05 Density .2 .25 Brazil, All Firms (149), 2000 0 5 10 ICR 15 Thailand Interest Coverage Ratio (Median), GDP Growth (%) & Interest Rates (%) 20 15 10 ICR GDP Int Rate 5 0 -5 -10 -15 1994 1995 1996 1997 1998 1999 2000 2001 The Findings Significant Business Cycle Effect • –1 Δ ICR Significant Sector Differences • -5% ΔGDP General Manufacturing Hit Hardest Significant Interest & Inflation Effects • Both Negative & Economically Large Developed and Emerging Markets Better fit for Emerging Markets GDP impact same DM sensitive to Inflation EM sensitive to Interest Rates Impact of a 5% Decline in GDP .04 0 .02 Density .06 .08 All Countries & Firms, EBITDA/Interest Expense, 2000 -50 -40 -30 -20 -10 0 ICR 10 20 30 40 50 Turnover & Margins EBITDA EBITDA Sales x TotalAssets Sales TotalAssets Returns correlated with Business Cycle Margin Effects Hard to Discern Turnover Effects Strongly Negative Conclusions Debt Service a major source of Vulnerability Business Cycle Impacts Significant Measuring Vulnerability Product Market Volatility Sensitivity to Business Cycle Does Market Structure Permit a Management Response?