Special Issue Focus - Credit Risks in 2019







As global interest rates have risen, increasing attention has been given to areas of credit risk that could be exposed by higher borrowing costs. Signs of slowing world growth in late 2018 and early 2019 are another potential source of heightened credit risk.

High-yield corporate credit spreads have risen significantly over recent months, but so far, there are few indications of a decisive upturn in actual credit defaults. The global speculative grade default rate edged down during 2018 to around 2.6 per cent (see Chart 1).

Defaults were low just before the last financial crisis as well, but nevertheless, low defaults are surprising given that world (non-financial) corporate debt has risen significantly over recent years, from 78.0 per cent of world GDP in 2011 to around 90.0 per cent in 2018. Previous run-ups in global corporate debt have been followed by sharp spikes in default rates, notably in 2001-02 and 2009.



A finer geographical breakdown of what has been happening to world corporate debt (bonds and loans) may help explain the lack of defaults up to now and give us an idea of where the main risk ‘hot spots’ are.

First, we note that while the global corporate debt/GDP ratio has risen a lot since 2011, the G7 ratio has been much more stable – and it is in G7 countries where the bulk of corporate defaults have tended to be in the past. Much of the rise in global corporate debt has been in emerging markets, especially China, where the default mechanism seen in G7 countries operates only to a limited extent.

However, this does not mean we can be relaxed about corporate debt risks. Even if credit distress does not show up in rising bond defaults, it may still cause problems in banks and lead to sharp slowdowns in growth in the affected countries. Indeed, emerging market non-performing bank loans have reached 5.0 per cent of the total, a full percentage point above their long-term average level.

Where do the main risks lie? The literature suggests we should be looking at both levels of debt and the rate of growth of debt. Cecchetti et al. suggest corporate-debt-to-GDP ratios above the 73.0-88.0 per cent range are associated with a heightened risk of financial distress, while studies such as Laeven and Valencia imply that rises in the debt ratio of 5.0-10.0 per cent over 3-5 years are also associated with sharply higher risks.

Using these thresholds, we identify three risk groups of countries (see Chart 2) – those with debt levels and debt growth above the risk thresholds (in blue), those with one of the debt level or debt growth above the thresholds (in tan), and those with neither (green). Corporate debt risks appear to be highest in Hong Kong, China, France, Canada and Chile. The next, more modestly risky group is larger and includes the U.S., Turkey, Sweden, the Netherlands, Australia, the UK and South Korea. Germany and Italy look relatively low risk.



The 2007-09 financial crisis showed that we need to be aware of risk concentrations within asset classes as well as aggregate debt levels – severe risk concentrations can cause significant financial distress even if aggregate debt levels look contained.

On this basis, an area of concern is that the average quality of corporate debt has been declining over recent years. In the U.S., the share of investment-grade credit rated BBB-/BBB/BBB+ has risen to nearly 50.0 per cent from 38.0 per cent in 2011, and is higher than in 2007 (see Chart 3).

Moreover, about a fifth of this broad BBB credit in the U.S. is rated at the lowest notch, BBB-, and thus at risk of downgrade into ‘junk status’. A large and rapid expansion of junk credit could disrupt credit markets, given many investors cannot hold junk debt.

The picture is, if anything, even worse in the Eurozone, where the broad BBB share was only around 20.0 per cent in 2011 but is also now around 50.0 per cent. Globally, the broad BBB share in investment grade credit has doubled from 24.0 per cent in 2007 to 48.0 per cent now.

The leveraged loan market (over US$1 trillion in the U.S. and mostly floating rate) is also seeing declining credit quality. In the U.S., around 50.0 per cent of such loans were issued at leverage multiples above 5x in 2018 – more than in 2007. In Europe, it was higher, at 60.0 per cent.

Turning to emerging markets, there is also evidence of deteriorating credit quality alongside higher debt levels. S&P find the share of highly leveraged firms (with debt-to-earnings ratios over 5x) has risen sharply since 2007 in key markets such as India, China and Thailand to around 40.0 per cent of the total. European levels are generally lower, apart from France at 35.0 per cent (see Chart 4).



There are also risks connected to household debt. If we divide countries once more into groups based on how their debt levels and recent debt growth compare with risk thresholds identified by the economic literature, we find that the riskiest countries appear to be Australia, South Korea and Canada.

We would also point to growing risks in China, where household debt has been growing at an exceptional rate, and where the level of debt compared to household income (rather than GDP) is over 100.0 per cent and has caught up with that seen in much more advanced economies.

Other countries where either household debt growth or the debt level look risky include Sweden, Hong Kong, New Zealand and the Netherlands (see Chart 5). U.S. and UK debt levels still look relatively high but are much lower than in 2007, and there is evidence that recent household credit expansion there has centred on households with better credit profiles. Larger Eurozone states generally have modest consumer debt.

Overall, our analysis suggests pockets of significant risk in global credit markets, though household debt, on the whole, looks less risky than corporate debt.

This update was researched and written by Oxford Economics, 121 St. Aldates, Oxford, OX1 1HB, England, as of 24 January 2019.