Stronger loonie a concern - gradualist approach needed from Bank of Canada

TORONTO, April 29 /CNW/ - At a time when Canadian consumers are sitting on record levels of debt, the country's corporate sector finds itself facing the opposite situation with its debt levels at record lows. This puts Corporate Canada in a strong position to withstand future interest rate hikes, finds a new report from CIBC World Markets Inc.

The report notes that corporate debt service payments are equal to about 30 per cent of total operating earnings today against 100 per cent or more at the time of Canada's last full blown recession in 1990-91. "While that's obviously simply a function in part of the lower absolute level of yields, it also reflects impressive deleveraging by many enterprises," says Peter Buchanan, senior economist and author of the report.

"In contrast to the household sector, corporate debt-to-equity ratios have declined more or less steadily in the last decade-and-a half. At the present record low of 54 per cent, the average is not only little more than half the level at the time of the economy's last full recession but about 15 percentage points below U.S. levels. Governments and corporations have made debt reduction a virtue bordering on saintliness, better positioning them for the Bank of Canada's looming policy turn."

Mr. Buchanan found that the recession of 1990-91 saw a dramatic change in Corporate Canada's attitude towards debt. Companies who levered to the hilt during the late 1980s to capitalize on NAFTA and other developments paid a high price, when the Bank of Canada drove yields to double digit levels to wrestle inflation to the ground. He notes that operating profits on an economy-wide basis fell by over 60 per cent in that painful episode, nearly twice the recent decline. Burned in that earlier episode by the one-two punch from rising rates and a stronger currency, corporations availed themselves of a subsequent strong earnings recovery, which saw the profit share double to 10 per cent of GDP over a four year period, to repair their distressed balance sheets.

"Current high corporate cash levels bear witness to Corporate Canada's conservative approach to balance sheet management in recent years, an approach likely to produce benefits as yields inch back up," adds Mr. Buchanan. "Cash levels in a number of key sectors like retailing are several times or more their average historical levels, normalized by sales."

Another fundamental change since the last recession is the corporate sector's evolution from a net borrower to a net lender. Corporations in the aggregate were net borrowers of as much as $20 billion per year in the early and late 1990's. In recent years, Canadian corporations have turned this around and now are net lenders of roughly the same amount.

The ability to fund a large part of their investment needs internally has helped reduce interest payments to external lenders over the last decade. On the borrowing cost side, a glance at spreads suggests that more prudent borrowing practices have not gone unrewarded. While Canadian companies did not fully escape the credit crunch, high quality 10-year corporates today trade much tighter to comparable U.S. issues than was the case 10-20 years ago.

"If there's a key concern for corporations in the Bank's prospective course change, it's likely less on the debt service cost side than the potential unwelcome lift to an already high-flying loonie," says Mr. Buchanan. "While the Canadian dollar's rags to riches story has to some degree simply mirrored the resource sector's turnaround, the currency's run-up has by some measures run further than warranted by developments in that sector.

"Non-resource manufacturers, who are vulnerable at home and abroad to competitors with significant non-Canadian dollar costs, arguably face the greatest adjustment burden when the dollar rises. A stronger currency is not, however, an unmitigated negative. Industries which use imported components, but face little direct import competition, like construction, typically see some benefit. Ditto for retailers selling now cheaper foreign products and firms catering to Canadian's appetite for suddenly more affordable foreign travel."

To get a better handle on the industry-level effects of changes in the Canadian dollar, Mr. Buchanan ranked industries based on the potential impact on both their foreign and domestic sales. He found that transportation equipment, clothing and machinery makers are among the largest potential losers from a higher loonie. The largest potential winners include construction, trade and various other service providers. A rise in the currency due to higher rates, though, is unlikely to be a clear cut positive for construction.

"Everything depends critically of course on how aggressively the Bank moves to reverse itself," adds Mr. Buchanan. "The Bank has cited both a lofty Canadian dollar and heavy consumer debt loads as presenting potential obstacles to a normal, healthy paced recovery in its recent pronouncements. That suggests, if anything, the Bank will err on the side of caution, which is good news given the recovery's continuing vulnerabilities on a number of fronts."

The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/sapr10.pdf

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