Covid-19 should flush out zombie performance from pre-crisis times

THE global pandemic was largely underestimated in the early days of the outbreak. Today, it has brought vast uncertainty, with the Singapore banks in recent times flagging current unknowns as relief measures mask the true damage of Covid-19.

But this uncertainty should not obscure an important pre-Covid factor: for certain companies, the pandemic would tip them into distress because they were structurally weak to begin with. This pressure point is particularly clear for consumer-facing sectors, and oil-related firms.

The Monetary Authority of Singapore's (MAS) annual financial stability review in late November showed there has been an uptick in leverage risk among Singapore corporates.

Since 2015, Singapore corporates overall have operated at around 150 per cent debt-to-GDP ratio, meaning that every dollar on GDP earned is tied to S$1.50 of debt taken by corporates. Reflecting years of loose monetary conditions that has kept cheap credit flowing, this ratio ticked higher to 157 per cent in Q2 2019.

The higher leverage has come largely from the property and commerce sectors, which accounted for an estimated two-thirds of overall corporate debt growth from 2010 to 2019.

Critically, both the commerce sector and the hotels and restaurants segment were flagged for risks in failing to meet their debt obligations. Their median interest coverage ratio (ICR) fell below two times in Q2 2019, meaning the amount of earnings before interest and taxes can cover less than twice of interest expense. An ICR of under two was the at-risk debt threshold for the MAS then.

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And while accounting for higher debt, the commerce sector in particular has shown eroding efficiency. The return on assets of the commerce sector - as determined by numbers from listed commerce firms - deteriorated in Q2 2019, falling to 1.7 per cent from 1.9 per cent a year ago.

So a good part of the consumer-facing sector walked into 2020 with higher financing costs and returns crimped by the rising debt burden.

Then Covid-19 struck, with these firms hit by lockdown measures.

The pain will be particularly acute for Singapore's small and medium-sized enterprises (SMEs).

An Experian analysis in May on more than 50,000 SMEs here showed that some 60 per cent of SMEs entered the crisis this year with a high risk of credit default, with the outlook already clouded in 2019 by the US-China trade war, a depressed manufacturing output and poor discretionary consumer spending.

These high-risk companies included those from the hospitality and F&B, as well as the retail sectors - two sectors that were also among the top three industries with the deepest negative profit margins.

Accounting for retail, food services and land transport, the consumer-facing domestic services make up 4 per cent of Singapore's GDP. MAS said in July that this sector will need time to recover to pre-crisis levels.

Going beyond the headline non-performing loan (NPL) ratio of Singapore banks, it's observed that the pandemic has a pronounced impact on general commerce as well. The trio saw their NPL ratios in Q2 2020 for general commerce loans rise to cross the two-percentage-mark.

Structural weakness is not limited to general commerce. The transport, storage and communication (TSC) sector remains in the doldrums from ongoing pain in the marine and offshore segment, having been slammed again this year. The fall in oil demand due to Covid-19 - and the dramatic collapse of agreements between the Opec cartel and Russia - triggered fresh hits to oil prices this year.

OCBC and DBS have 11 per cent and 9 per cent respectively of their loans to the TSC segment souring. OCBC in Q2 this year crunched down its exposure to the offshore support segment to negligible levels by taking a hefty provision, signalling that it does not see recovery anytime soon.

A harder look at numbers comes as analysts have said it would be difficult to pinpoint the final impact of "zombie companies" in the system.

And given the record relief measures doled to corporates, it is tough for now to clearly separate firms that were skating on thin ice before Covid-19 hit, and those which have been overwhelmingly hammered by the pandemic.

For example, with TSC including air transport, the pain in that sector will be compounded by a paradigm shift in air travel.

And while construction firms were ranked by Experian as the second worst showing in terms of negative profit margins among SMEs - trailing just the hospitality and F&B segment - there was no dramatic uptick in banks' NPLs ratios for this sector in Q2, despite expected project delays amid the pandemic.

Still, it remains that there were signs of debt-driven weakness even before the health crisis hit.

MAS's stress test in 2019 signalled that the proportion of firms that risk crumbling under interest rate and earnings shocks is about 30 per cent, after accounting for cash reserves and hedging. The test assumed interest costs rose 25 per cent, while earnings before interest, tax, depreciation and amortisation fell by 25 per cent.

That was then.

It's safe to assume some at-risk companies made no sales during the lockdown this year. It is unlikely that revenues have fully recovered.

Weak fundamentals may have also been compounded by shadow banking, as fintechs step in to offer credit to smaller businesses already on the decline. The extent of this remains a question mark.

So once relief measures unwind, and higher interest costs meet weak revenue, the three-in-10 estimate for at-risk firms is one to watch - for Singapore banks, and the economy.

The pandemic has sparked questions of how it will reset economies, with a looming question over whether public finances here should continue to be used to support struggling businesses in certain quarters.

Singapore is now managing how it should withdraw relief, in order to mitigate risks of a "cliff effect". Careful calibration is needed to prevent a chaotic exit in this annus horribilis caused by a black swan event.

But this concern should not ignore that some companies drunk on debt need to be stirred out of a discernible lull in innovation and efficiency. The pandemic may dish bitter medicine to those who failed to thrive in better times. For Singapore to stay resilient in post-Covid times, such reckoning looks increasingly inevitable.