IMF warns of corporate loan default problems in Spain, Portugal and Italy

The International Monetary Fund on Wednesday raised the alarm about the potential fallout from high corporate debt in peripheral euro-zone countries such as Spain, Portugal and Italy, added to the fact that interest rates in these countries are higher due to their sovereign-risk premiums.

“In the stressed economies of Italy, Portugal and Spain, heavy corporate sector debt loads and financial fragmentation remain challenging,” the IMF said in its latest Global Financial Stability Report.

The report said if there is no further improvement in financial and economic conditions, then some banks in these countries might have to further increase their provisions for bad loans, absorbing a large part of their future earnings. The European Central Bank’s pledge to do everything in its power to save the euro has helped to ease both Spain and Italy’s risk premium, but that alone is not enough, the agency wrote.

“Even if financial fragmentation is reversed over the medium term, this report estimates that a persistent debt overhang would remain, amounting to almost one-fifth of the combined corporate debt of Italy, Portugal and Spain.”

The IMF highlights the fact that more than three-quarters of corporate debt in in Portugal and Spain, and about half of corporate debt in Italy, is owned by companies with debt-to-asset ratios of 40 percent or more. In addition, almost 50 percent of debt in Portugal, 40 percent of debt in Spain and 30 percent of debt in Italy is owed by firms with an interest coverage ratio of less than 1 percent.

“These firms would be unable to service their debts in the medium term unless they make adjustments such as reducing debt, operating costs or capital expenditures,” the IMF said.

The IMF has been concerned for some time about latent bad loans in the Spanish banking system deriving from credit that has been refinanced. In response to this, the Bank of Spain has tightened the criteria used to define healthy loans, which in practice has forced the banks to increase provisions by some five billion euros. As of April, Spanish banks had 127 billion euros of refinanced loans on their books, 12 percent of total outstanding loans in the sector.

However, Spain’s lenders are in a relatively more comfortable situation than their peers in other countries in this respect, the IMF’s director for financial and monetary affairs, the Spaniard José Viñals, said. In an adverse scenario in which bad loans would cause potential losses for banks of some 104 billion euros in two years, this would be covered by current provisions in Spain.

Viñals was deputy governor of the Bank of Spain in the period 2006-2009, during which time a massive real estate bubble burst and corporate and household debt hit record levels.

The IMF noted that banks in Spain have reacting to the increased riskiness of loan defaults in the current economic environment by further raising borrowing costs and constraining lending, thereby putting a stranglehold on the potential recovery in the economy, causing a potential vicious circle in that they further increase the risk of defaults.

“Debt overhang in banks, firms and households is the key factor constraining credit volume in Spain,” the report concludes, adding that if the influence of sovereign and bank stress is removed, current interest rates on new small loans would be about 160 basis points lower in Spain.