We have found that value destruction in the real sector is one of the funda- mental causes and earlier warning signs of a financial crisis. In most of the cases we have seen, the real sector was suffering economic losses, gradually destroying itself for years prior to the crisis. At the same time, risk in the portfolios of the financial intermediaries funding these businesses was grad- ually—and sometimes, rapidly—mounting. If left unchecked, this danger- ous confluence could easily spiral into a financial crisis. Conversely, we found that countries that did not go into crisis (such as the United States) did not show value destruction in the real sector but, rather, value creation.
(See Appendix 3.2: Estimating Value Destruction in the Economy.)
This weakness in the real sector is the common theme in crises world- wide. In Mexico and Argentina (and most of Latin America, as well as Turkey and Sweden), corporations that failed to perform well were exposed through well-intentioned market reforms that heightened competition to levels that they previously had not faced. As a consequence, many of these same corporations went into an even steeper decline as part of a necessary but painful free-market therapy.
1. Real economy dynamic Performance of
borrowers/
corporates
5. Asset pricing dynamic
3. Government macroeconomic policy
dynamic
4. International money and capital market
dynamic
2. Financial intermediation*
dynamic
Asset value Liquidity
Economic activity
Credit volume
* Includes nonbank financial intermediaries
Sustainability of the economy
*Includes nonbank financial intermediaries Source: McKinsey practice development
FIGURE 3.2 Dynamic economic loops drive financial crisis.
In other cases, such as Japan, Korea, Thailand, and Indonesia, the com- panies were sheltered somewhat from direct foreign competition, but they still suffered from traditional industry structures and misguided industrial policies that encouraged overinvestment in key sectors and protectionism which lulled domestic corporations and caused them to delay needed changes. In still other cases, such as China, Russia, Romania, and the Czech Republic, the real sector suffered because of decades of government inter- vention in the economy.
In each case, the performance problems of the corporations are made evident by the fact that their return on invested capital (ROIC) was insuffi- cient to cover their weighted average cost of capital (WACC). That a few corporations should be failing at any point in time is not surprising. In fact, it is actually a normal manifestation of a healthy economy’s transformation over time, or what economists since Schumpeter have referred to as the process of “creative destruction.” When this is the case for a significant number of the leading companies of a country, across the breadth of the entire economy, however, crisis conditions could be building.
In Korea, for instance, corporations were able to cover the pre-tax cost of debt in only four of the fifteen years preceding the crisis (Figure 3.3). To put this in the proper perspective you must understand that the electronics sector, and to a lesser extent the steel industry, skewed the average by far
11.7
3.6
10.3
6.9
11.1
10.5
27.2 12.6
11.3
13.4
11.8
11.6
9.3
14.5 ROIC vs. cost of debt
15-year average
0 0.05 0.10 0.15 0.20 0.25
1981 83 85 87 89 91 93 1995
Value destroyed
Value created Pre-tax ROIC = 11.9
Pre-tax cost of debt = 13.0
VALUE WAS DESTROYED IN MOST KOREAN INDUSTRIES Percent
Construction
Automotive
Tool
Textile
Chemicals
Steel
Electronics
Pre-tax ROIC Pre-tax cost of debt
*ROIC = NOPLAT (net operating profit less adjusted taxes)/invested capital Source: Bank of Korea; McKinsey analysis
FIGURE 3.3 Value was destroyed in most Korean industries.
outperforming the rest of the industry. In the Korean economy, then, only two sectors created value. All the rest were using capital inefficiently.
Korea’s failure is even more apparent when its average ROIC of less than 12 percent is compared to that of the United States, where the average ROIC during the same period was almost 19 percent.
A similar but much more dismal story emerges when one examines Mexico in the four years preceding its 1994–1995 crisis (Figure 3.4). During this entire time, its companies destroyed more value than they created. Only telecommunications earned a return higher than its after-tax cost of debt, and that sector’s performance was heavily influenced by Telmex, which was operating as a monopoly, had a stranglehold on long distance service, and benefited from regulated rates. Overall, Mexico’s corporate sector perfor- mance was far lower than its WACC—lower even than Korea’s. (See Appen- dix 3.3: Why Corporate Sectors Underperform in Crisis Economies.) Timing Crises by Tracking Interest Coverage Ratios
Tracking value destruction in the real sector does raise a problem, however.
When does value destruction signal a crisis, rather than merely a sluggish economy? To solve this problem, we have found the need for a more finely tuned metric—the interest coverage ratio (ICR). ICR, which also is used by Standard and Poor’s in its ratings of companies, is calculated by dividing
0 2 4 6 8 10 12 14
1991 1992 1993 1994
-3.6 1.1
2.5 5.0
5.5 5.5 5.8 7.0
7.4 8.1
9.2 9.3
15.1 7.2
CRISIS
ROIC (nonfinancial sector) Percent
* Conservative estimate based on spread over after-tax cost of debt After-tax ROIC
After-tax cost of debt
Airlines
After-tax ROIC by sector – 1991-94 Percent
Value destroyed*
Average after-tax cost of debt 10.5%
Steel Mining Others Manufacturing Retailing
Diversified conglomerates
Construction Cement
Paper
Media & Entertainment Food & Beverages Telecom Weighted average
*Conservative estimate based on spread over after-tax cost of debt
Source: Bloomberg (sample of 120 companies); IMF; McKinsey analysis; Standard & Poor’s
FIGURE 3.4 Most Mexican companies destroyed value prior to the crisis.
projected EBITDA (earnings before interest, taxes, depreciation and amorti- zation) by the projected cost of paying the interest on the debt of the com- pany over the same time period. Working with the value destruction database of a few countries, we found that when ICR dipped below 3.0, the debt-service capacity of the key industries of the corporate sector was exhibiting growing fragility (Figure 3.5).9When the indicator fell to 2.0 or below, we read it as indicating almost certain problems in the loan portfo- lios of financial institutions. To be sure, a level of 2.0 for an individual com- pany does not necessarily signal immediate distress, but when an entire corporate sector has such a low debt-service capacity, the system has little room left for error. Standard & Poor’s provides ICR medians for the various debt rating categories (AAA to CCC) by industry sectors.
Other Crisis Warning Signs
There are two other tools to use as crisis-tracking indicators. The first is a high debt-leverage ratio. This indicator is simple to estimate—it requires dividing the sum of bank debt and bonds by shareholder equity. Generally, levels under 50 percent are easily borne, but as these mount and get closer to 100 percent, the vulnerability of companies is high. In the Korean case, long before the crisis, debt-to-equity ratios had grown far beyond what prudence dictates. For instance, on the eve of the crisis the average ratio for the top twenty chaebol stood at 425 percent, far higher than was sustainable.10
Interest coverage ratio*
3.1 2.3 2.4 2.2 2.3 2.4 2.0 1.9
1.2 2.0
4.7 3.9 4.0 3.5 3.5
2.9 2.3
1.6 1.0 1.8
9.4
7.1 6.5 6.7
7.9 7.4 5.1
4.2
2.4 3.0
1990 91 92 93 94 95 96 97 98 1999
1990 91 92 93 94 95 96 97 98 1999
1990 91 92 93 94 95 96 97 98 1999
PRIOR TO CRISIS
Korea
Thailand
Malaysia
Crisis
*Interest coverage ratio is calculated as EBITDA/interest payments of the same time period Source: Bloomberg; McKinsey analysis
FIGURE 3.5 Corporate sector’s ability to service debt decreased prior to crisis.
The second test of the sustainability of corporate sector growth requires an assessment of the quality of corporate governance. This is a judgment call, of course, but we think it can be made by asking four tough questions:
In the economy in question, are corporate disclosure rules well-defined and commonly practiced? Do minority investors have well-defined legal protec- tions? Are the fiduciary obligations of corporate boards well-defined and established? Do independent board members have significant roles in board decision making?
The United States and the United Kingdom are supposed to have the best financial practices in the world. The recent U.S. public debate, how- ever, highlights the importance of protecting minority shareholders and having independent boards, audit committees, and transparent financial dis- closure practices. Poor corporate governance has been a factor in every crisis we have studied. While good governance practices help corporations achieve a higher performance level, the real impact of poor governance practices is expressed in a more indirect way: When governance practices are poor, the risks borne by minority shareholders and creditors are disproportionately high.
Hence, if other signs suggest that a storm is brewing, companies operating in countries with weak governance practices should pay especially close attention.