Inflation and Loan Losses (II)

In the first article about inflation and Loan losses I focused on households. In this article I continue exploring the topic but by focusing on corporate clients, sovereigns and exploring a bit more the connections we can see with the GDP.

Corporates with lower pricing power and higher debt are more exposed to default than other corporates.?While some firms can pass on cost increases to consumers, other firms with less pricing power may face cost increases that outpace revenue growth. Smaller and more indebted firms might have typically lower pricing power:

In the first article about inflation, we saw that:

?But there was no specific reference to the dynamics of the GDP in this context of high inflation. GDP is defined as:

?It can be argued that theoretically, both nominal interest rates and nominal growth rates could increase with inflation. Let’s look into the different type of inflation:

1. Demand-pull: when the demand for certain goods and services is greater than the economy's ability to meet those demands, therefore putting an upward pressure on prices.
2. Cost-push: when the cost of wages and materials goes up and these costs are then passed to consumers in the form of higher prices for those goods and services.
3. Imported: when the cost of the imported products or services used by companies in a country rises.
4. Wage/price-spiral inflation: when rising wages increase disposable income raising the demand for goods and causing prices to rise.

?We started by having inflation driven by a demand-pull in the post-covid context that was then paired with an inflation driven by more cost-push/imported drivers generated by higher energy prices. In this later case (cost-push/imported), the scope for higher income is more limited. The differential between interest rate and growth would tend to increase and therefore creating an additional risk for indebted sovereign countries:

Despite this, it should be noted that some of the countries, for example in Europe, more exposed to these risks have been improving their debt structures by increasing the average residual maturity and expanding the investor base. This allows these countries to improve their interest rate-growth differential during the early stages of an inflationary shock if nominal GDP growth is sharp, while the average interest rate paid on the total debt stock adjusts only gradually.

So, we probably end up with a scenario where Investment (I) is down given the decrease in risk taking (effect 1) and governments of indebted countries will try to lower the nominal outstanding debt therefore limiting the Government Spending (G).

?Finally, the expected output growth will face downward pressures when nominal rates increase, with consumer confidence spiralling downward and negatively impacting the consumption and GDP (ceteris paribus):

So, the perspective is grim for all the GDP components except Net Exports that can contribute to attenuate the fall, given the higher external competitiveness of the home devalued currency.

To be continued...

Sources:

https://www.ecb.europa.eu/pub/financial-stability/fsr/focus/2022/html/ecb.fsrbox202205_03~df74747300.en.html

Credit Risk: The Easy Path. From Rookie to Expert, Asif Rajani, 2022.