Strong balance sheets spare us the worst
As the economic cycle turns down, many companies raise savings, but the corporate sector tends to go into debt
Monday 10 August 1998
The principal problem for companies has been an overvalued exchange rate. Taking account of changes in relative labour costs and Asian currency developments, we estimate there has been almost a 50 per cent loss of international competitiveness since early 1996. UK plc is now as uncompetitive as it was in the early 1980s - another period of substantial currency overvaluation. Indeed the scale of the overvaluation is much more severe than when the UK was in the ERM between 1990-92.
To date, much of the deterioration in the UK's trade position can be explained by Asia. Export volumes to the region have collapsed. Import penetration from Asia appears to have risen significantly. The recent collapse in export orders, though, is indicative of far more widespread difficulties. Initially the problem was disguised by the way exporters in general took the currency hit on margins, cushioning the impact on orders.
Perhaps the situation could have been salvaged if the extreme overvaluation of sterling last year had proved temporary. However, as sterling became increasingly overvalued it became more and more likely that UK plc would eventually be priced out of international markets.
If things were not bad enough, orders are now falling in Germany, the hub of the UK's most important export market, Europe.
A collapse in export orders may have been delayed, but it has been evident since early 1996 that profit margins were coming under increasing pressure. Given the scale of the overvaluation of sterling and global developments it is easy to see a profit downturn on a similar scale as in the early 1990s. This is worrying. Recessions have almost always been preceded by falling profits.
Why, then, not deep recession this time? One crucial difference this time around is the strength of balance sheets. There has never been such a contrast between profit weakness and balance sheet health as there is today.
In previous downturns profits deteriorated against a background of suspect balance sheets. Balance sheets got rapidly worse. Deep recessions followed as liquidity constraints forced companies to retrench rapidly.
The situation this time around is very different, as the chart indicates. The blue line confirms that corporate earnings growth has been slowing for two years and is now moving into negative territory.
The red line shows a very different picture of corporate sector health. Outstanding bank deposits of industrial and commercial companies is shown as a proportion of their outstanding bank borrowings, the so-called liquidity ratio. This stood at a historically high level in the first quarter of this year.
But hold on. Surely a profit downturn will rapidly bring deterioration in balance sheets? Yes, but the point is that the starting point is so good that there is a huge cushion.
Prior to the last recession, it was relatively commonplace for commentators to argue that improved inventory control reduced the need for de-stocking as the cycle turned down. This may have been the case. However, despite historically relatively low stock-output ratios, companies were faced with very little choice on liquidity grounds but to cut stockbuilding. Indeed the eventual de-stocking was on a scale with the 1980-81 downturn and the 1970s recession. This could have been forecast by looking at the behaviour of the liquidity ratio.
The unprecedented contrast between corporate earnings and balance sheets is just an additional uncertainty for forecasting the UK economy. The severity of the current downturn will depend in large part on which factor proves the more important.
Most likely both factors will play a role. The severity of the downturn in profits is such that a hard landing is inevitable. However, companies will make use of their balance sheet strength to avoid more savage retrenchment.
As the economic cycle turns down, many companies may raise precautionary savings, but the corporate sector as a whole tends to go further into debt.
To put the current strength of balance sheets in context, companies could increase their outstanding bank borrowings by around pounds 85bn for the liquidity ratio shown opposite to fall back to its previous record lows.
The current strength of balance sheets is largely a reflection of one of the principal causes of the last downturn, debt. Companies scared by the memory of the last recession and seeing little reason to invest in the early stages of this recovery made it a priority to restore balance sheets.
This caution puts them in better shape to withstand the effects of a substantially overvalued exchange rate. Not only that, but base rates are likely to have peaked at half the level of the last cycle
The absence of liquidity constraints should rule out de-stocking on the scale of the last recession. IT problems related to the Year 2000 problem along with balance sheet health should provide additional momentum to investment. Company hiring plans will be scaled back as profitability slips, but there should be much less in the way of enforced redundancies than seen in the early 1990s. We may also continue to see many companies continuing to pay up for skill shortages.
On balance sheet grounds some sectors are clearly more insulated from corporate hard landing than others. Latest data provided by the Bank of England contrasts the balance sheet strength of business services with much of the catering industry.
Within manufacturing there are clear contrasts between some of the more "high tech" sectors where balance sheets are strong, and food, drink, tobacco and textiles. Survey evidence suggests thatsmall unquoted companies continue to look more vulnerable.
Where does this all leave the MPC at the Bank of England? As already highlighted, even the current strength of balance sheets cannot avoid an extremely sharp slowdown in growth. Indeed given the degree of overvaluation of sterling, a prolonged period of below trend growth seems very likely and the risk of technical recession (two consecutive quarters of negative growth) is significant.
But if companies do not exacerbate a demand slowdown by savage retrenchment, will the economy slow enough to ease inflationary pressures? Thishinges on one's belief about where the level of activity is in relation to the economy's potential output. In our judgement, the extent of overheating was exaggerated.
The weight of evidence is that the slowdown is spreading out of manufacturing into services and consumption. The trend toward outsourcing in the 1980s and 1990s has made the service sector more dependent on manufacturing, services could never insulate themselves completely from an overvalued pound.
Accordingly in the next six months confidence will grow that a slowing economy will not be accompanied by the inflation hangover that has typified many previous slowdowns. As such we can hope that not only have interest rates peaked, but that rate cuts are possible by year end.
David Owen is the UK Economist and a Director of Dresdner Kleinwort Benson.
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