Borrowing Binge Weakens Europe's Companies as Recession Looms

By Simon Kennedy

Sept. 8 (Bloomberg) -- European companies may be living on borrowed time.

A decade of investing more than they've earned in profits has loaded corporations in the 15-nation euro area with debt, leaving them a thinner cushion than their U.S. and Japanese counterparts as the world economy slumps. Companies including France's Renault SA and Thomson SA are under pressure to curtail hiring and capital spending to meet rising interest payments as weaker growth squeezes their profits.

That increases the threat of a prolonged slowdown for the euro-area economy, which contracted in the second quarter for the first time since the single currency began trading in 1999. Economists at Deutsche Bank AG predict investment will shrink in 2009 for the first time in seven years, leaving the economy to grow just 0.1 percent for the year while the U.S. expands 1 percent.

``The size of the debt imbalances makes it very difficult to envisage a strong euro-zone economy over the next year or so,'' says David Owen, chief economist at Dresdner Kleinwort Group Ltd. in London. ``It increases the risk of recession.''

For Europe's non-financial corporations, the gap between profits and investment rose to 4.5 percent of annual output last year, compared with 3.6 percent for their counterparts in the U.S., Citigroup Inc. estimates. Exclude companies in Germany, where earnings still outstrip investment, and the gap swells to 6.6 percent.

Burdened With Debt

The result: Europe's non-financial companies are burdened with 5.3 trillion euros ($7.6 trillion) of debt, equal to about 57 percent of the euro-zone economy. That's up from 48 percent before the 2001 slowdown and compares with 46 percent in the U.S., according to data from the Federal Reserve and the European Central Bank.

U.S. companies such as San Jose, California-based network- equipment maker Cisco Systems Inc. entered the slowdown with more than half a trillion dollars in cash they accumulated earlier in the decade by reducing debt, controlling spending and keeping inventories in check. That means they are under less pressure now to cut payrolls and investment.

Japanese firms may be even healthier after ridding themselves of idle factories and excess workers. Robot-maker Fanuc Ltd. amassed $5 billion in cash this decade after paying off $8 billion in long-term debt between 1995 and 1999. Mizuho Research Institute Ltd. forecasts corporate spending will help Japan's economy, which shrank in the last quarter, rebound faster than Europe's or America's.

Cheap Credit

European companies, on the other hand, took advantage of cheap credit to increase borrowing, allowing them to make acquisitions and boost investment for 20 straight quarters. French drugmaker Sanofi-Aventis SA, for example, took out a 16 billion-euro loan in 2004 to pay for the merger that formed the company.

Corporations in all sectors accelerated their borrowing in 2005-2007, adding 1.8 trillion euros to their debt, mostly in bank loans, according to Mark Wall, an economist with Deutsche Bank in London.

Now, he says, those companies are ``under attack from both sides'' as they attempt to manage their financing costs. Their profit margins are squeezed by slowing demand, record fuel costs and rising wages. At the same time, banks, trying to rebuild their own balance sheets, are tightening standards and demanding higher interest rates to make new loans or refinance current ones.

Borrowing Costs

The cost of borrowing in euros for three months -- a benchmark that determines the rate on bank loans such as Sanofi- Aventis's -- has jumped about 66 basis points, or 0.66 percentage point, since the beginning of August 2007 and stands near the highest level since December 2000. Banks told the ECB this quarter that they expect to tighten lending standards further.

Germany has already been down the path that economists foresee elsewhere in Europe. Having sunk money into the technology bubble of the 1990s, German companies were forced to slash spending in the 2001-2004 period as growth slowed, leaving Europe's largest economy lagging behind the subsequent recovery elsewhere in the euro region.

That means German companies are less burdened with debt now and less in need of curtailing their borrowing, says Jacques Cailloux, an economist at Royal Bank of Scotland Group Plc in London. ``Germany is bucking the trend,'' he says.

Most in Hock

This time, Spain's companies are the most in hock after their debt doubled since 2000 to 129 percent of the country's GDP amid a housing boom, according to Standard & Poor's.

In the bust that followed, property developer Martinsa- Fadesa SA became Europe's largest bankruptcy in five years in July when it defaulted on 5.2 billion euros of debt. Its biggest rival, Metrovacesa SA, said last month it will increase asset sales to reduce the 7.5 billion euros it owes.

One sign of growing concern about the ability of companies to handle their debt: So far this year, Moody's Investors Service has cut long-term credit ratings on 216 European companies, including Hanover, Germany-based tiremaker Continental AG and vodka producer Belvedere SA, in Beaune, France, while raising grades on just 81. In the same period last year, it lowered 237 and increased 497.

Belvedere obtained protection from creditors in July. Harsher terms for companies that are restructuring what they owe may lead to a quadrupling of defaults on high-risk loans in Europe to 5.8 percent by June 2009 from 1.55 percent in the same month this year, S&P said last week.

Rating Cut

In August, S&P cut the credit rating for Thomson, the world's largest provider of television set-top boxes, by one grade to B+, partly because the company's 1.3 billion-euro debt left it with ``high leverage'' after its biggest half-year loss since 2005, S&P said. Thomson is seeking to reduce expenses by 50 million euros this year.

Other businesses are retrenching as well: Capital spending grew at an annual rate of 0.8 percent in the first half of this year, compared with 4.2 percent in the prior six months, according to JPMorgan Chase & Co. Confidence among manufacturers dropped in August to its lowest level since May 2005, and production expectations were the weakest in almost seven years, a European Commission survey showed. A poll of 5,000 executives by Markit Economics found that firms cut employment for a third month in August.

`Increasing Uncertainty'

Renault is eliminating up to 6,000 jobs and trimming output. S&P cut its outlook for Europe's second-largest automaker to negative in July, amid ``increasing uncertainty on Renault's ability to maintain sound cash generation.''

Also feeling a pinch is Helios Domzale d.d., a Slovenian paintmaker. Its first-half profit fell as orders weakened and debt costs increased. ``We've had to reassess investment plans and postpone some for next year,'' Chief Executive Officer Uros Slavinec said in an interview last month.

``More pain probably lies ahead,'' says Michael Saunders, chief European economist at Citigroup in London. ``Worsening corporate finances add to downside risks to growth.''

To contact the reporters on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net