Since the onset of the pandemic, non-financial businesses have improved their balance sheets through reduced leverage and increased cash reserves. However, the pace of cash accumulation has decelerated, with larger businesses demonstrating a more substantial growth in cash buffers in comparison to smaller businesses.
Despite increased input expenses, robust demand following the pandemic has enabled most companies to recuperate their profit margins. Majority of firms have reverted to pre-pandemic operating profit margins levels, although the construction industry has encountered specific challenges. Higher energy costs have not significantly impacted firms’ margins, with energy-intensive industries, such as transportation, preserving their profit margins.
Small businesses with high levels of debt are more vulnerable to rising interest rates compared to larger businesses, as they may struggle to service increased interest expenses due to ongoing cost pressures and income volatility. Conversely, large businesses, particularly those listed on the ASX, have hedged interest rate exposures and issued long-term fixed-rate debt, thereby postponing the influence of increased interest rates on their debt-servicing expenses. As of December 2022, most ASX-listed companies had sufficient liquidity and profits to address their interest expenses, even for unprofitable companies.
While company insolvencies have risen to levels comparable to pre-pandemic periods, they generally remain low. Predominantly, insolvencies involve small businesses with annual turnovers below $2 million, and the impact on households and other businesses is limited. The construction sector is particularly impacted, accounting for approximately 30% of insolvencies, due to margin pressures and delays caused by labor and materials shortages. The recent increase in interest rates has also added to debt-servicing costs for many firms. However, the overall financial system and economy are expected to experience only a modest impact, unless a significant increase in insolvencies among larger companies affect households and other businesses.
Businesses with inflexible cost structures are at risk during period of weakened demand, as they may struggle to transfer increased input costs, resulting in margin pressures. Industries such as arts and recreation, as well as business services, generally show less flexible operating costs compared to retail, transportation, and wholesale firms, as indicated by a study of larger entities with annual revenues of at least $10 million.
The retail and office leasing markets continue to face challenges, with high vacancy rates in central business districts (CBDs) and market rents remaining below 2019 levels due to reduced demand. However, demand for industrial properties remains strong, driven by the transition to e-commerce, which has led to increased rents for distribution and warehouse spaces. Nevertheless, recent valuations for office and industrial properties have experienced pressure from rising interest rates, and further declines are expected as more transactions occur at lower prices in a higher interest rate environment. The recent surge in financial market volatility contributes to uncertainty surrounding the extent of these declines, and the downward adjustment of asset book may affect the balance sheets of commercial real estate owners and lenders.
Commercial property risks may intensify during an economic downturn, potentially resulting in financial distress for some landlords. Australian real estate investment trusts (A-REITs), which hold a significant share of commercial properties, are generally well positioned to withstand reductions in rental income and valuations. However, leveraged investors may face refinancing challenges if loans fail to meet minimum interest coverage or maximum loan-to-value ratio (LVR) requirements. Australian banks maintain limited direct exposures to commercial property and adhere to conservative credit policies, while risks within non-bank sector are restrained due to its modest size.
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