IMF sharpens warnings on corporate debt after rate cuts

The International Monetary Fund (IMF) heightened its warnings for the corporate debt market on Wednesday, as investors search for richer returns in riskier assets after recent interest rate cuts by central banks.

The IMF, whose fall meetings with the World Bank begin in Washington this week, also warned that the main drivers of downside risks to the global economy remained ongoing trade tensions and policy uncertainty.

A major geopolitical event, like the United Kingdom exiting the European Union without an agreement, could trigger a sharp tightening of financial conditions, said the IMF in its biannual Global Financial Stability Report.

The Washington-based organisation and other economic policymakers have expressed concern over high levels of risky corporate debt in the past. But it said on Wednesday that attempts by central banks worldwide to lower interest rates to combat immediate economic risks has exacerbated the situation, leading to “worrisome” levels of debt with poor credit quality and increasing financial vulnerabilities over the medium term.

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The IMF warned that 40 per cent of all corporate debt in major economies could be considered “at risk” in another global downturn, exceeding levels seen during the 2008-2009 financial crisis.

“While easier financial conditions have supported economic growth and helped contain downside risks . . . in the near term, they have also encouraged more financial risk taking and a further buildup of financial vulnerabilities,” noted the report. The IMF warned that investors may be “overly complacent” about downside risks this late in the economic cycle.

On Tuesday, it cut its 2019 global growth projection to its lowest level since the financial crisis, largely due to ongoing trade feuds. The IMF singled out rising risks in corporate and non-bank financial sectors as a source of concern. Investors, facing lower interest rates, are taking on more illiquid investments with weaker investor covenants in search of higher rates of return, it said.

Why are valuations ‘stretched’?

The US Federal Reserve has cut rates twice this year amid concerns that slowing global growth and trade tensions could spill over to the broader economy. Meanwhile, central banks elsewhere, including the European Central Bank and Bank of Japan, have kept interest rates in negative territory in a bid to spur lending. "The search for yield in a prolonged low-interest rate environment has led to stretched valuations in risky asset markets around the globe, raising the possibility of sharp, sudden adjustments in financial conditions," the report stated.

Specifically, the IMF said a global downturn half as severe as the one spurred by the last financial crisis would result in $19 trillion of corporate debt being considered “at risk,” which the IMF defines as debt from firms whose earnings would not cover the cost of their interest expenses.

The IMF also cautioned that the low-interest rate environment has driven up demand for debt in emerging and frontier economies, with external debt climbing to 160 per cent of exports, compared to 100 per cent in 2008.

In a sharp downturn, it could become difficult to sustain or roll over those large debt obligations. To guard against these risks, the IMF urged policymakers to maintain “robust and rigorous” financial regulation and supervision, and urged policymakers to activate broader macroprudential tools, such as countercyclical capital buffers. The IMF also said policymakers “urgently” need to develop better tools to monitor risks in the corporate sector. – Reuters