Brussels, 5 October 2010
Corporate balance sheet adjustment shapes euro-area economic outlook
The Third Quarter 2010 edition of the Quarterly Report on the Euro Area highlights that although output growth in most euro area Member States has improved, the ongoing balance sheet adjustment process in the corporate sector will influence the recovery ahead. The analysis of previous episodes of corporate balance sheet adjustment shows that they have been associated with sizeable negative macroeconomic consequences, including weak GDP growth due to lower investment rates and falls in labour compensation. It is therefore crucial to counteract these dampening forces on growth by frontloading growth-enhancing reforms. Furthermore, the Report looks into past episodes of adjustments to large current account deficits as well as misalignments in house prices in the euro area.
This edition of the Quarterly Report on the Euro Area features a thorough assessment of the process of corporate balance sheet adjustment, i.e. of changes to the level and composition of corporations' asset and liability positions. Although such changes occur constantly to a certain extent, as firms adapt their financial structure to changing economic conditions, the analysis reveals that balance sheet adjustments can have important macroeconomic consequences following periods of corporate over-indebtedness, strong business cycle downturns, stock market declines and losses in potential output. It also shows that problems in the financial system can aggravate corporate balance sheet adjustment. The analysis of 31 previous episodes of corporate balance sheet adjustment suggests that significant balance sheet changes should be expected for a considerable period of time, and these have indeed already been visible in the recent past.
The main macroeconomic effects of balance sheet adjustment that were evident in previous such episodes include, first and foremost, weak GDP growth for a protracted period (around 8 years on average). This weakening of GDP growth during balance sheet adjustment phases is driven by two distinct phenomena: Firstly, corporate investment tends to fall during the adjustment phase, which enables companies to cut overall expenditure and thereby reduce their net borrowing from other sectors of the economy. However, this also reduces domestic demand in the economy and hence slows output growth. Secondly, to raise the internal funds to adjust their balance sheets, corporations tend to cut their wage bill, thereby placing a drag on disposable income and, ultimately, private consumption.
Since the beginning of the global recession, corporations in the euro area have significantly reduced their borrowing from the rest of the economy through balance sheet adjustments and have even turned into net lenders. Part of this appears to be cyclical, as was the case in previous downturns, but there are further reasons to be concerned about protracted structural forces at work that could weigh on the euro area recovery. These include the existence of a debt overhang, frequent changes in risk attitudes and possible declines in potential growth rates. The negative consequences of balance sheet adjustment on economic activity could be magnified unless appropriate policies are not put in place.
The report suggests taking action in three areas: Firstly, addressing remaining problems in the banking sector is essential for laying a solid foundation for the recovery. Secondly, economic policies need to be geared towards boosting potential growth, and such policies should be front-loaded to the greatest extent possible. Finally, corporations' access to equity capital should be improved, so as to reduce the need for balance sheet adjustments to be funded through internal savings such as cuts in investment and the wage bill.
The Report further features a number of special topics on the euro-area economy, dealing with countries' current account adjustment, housing market overvaluation, and an analysis of the Greek export sector.
Key findings are:
Correcting current account deficits generally entails a period of sluggish growth and rising unemployment. However, this can be mitigated if prices and wages respond appropriately and competitiveness is improved, especially within the Economic and Monetary Union. So far, there have been only a few signs of rebalancing of prices and competitiveness across the euro area and further efforts are clearly needed here.
For Greece, encouraging signs for a rebalancing of supply towards the export sector exist as a high proportion of companies are involved in export activity. This suggests that the important competitiveness-boosting reforms foreseen in Greece' economic adjustment programme are likely to pay off all the more quickly.
Real house prices in the euro area have decreased significantly since the beginning of the global economic and financial crisis. They now appear to be much closer to their equilibrium values than in the US or in the UK, notwithstanding considerable heterogeneity between Member States. This comparatively healthier position of the housing market in the euro area as a whole is good news for a future recovery in housing investment and private consumption.
QREA report on: