The Financial System's Weak Link: Zombie Firms
Whether you think of subprime mortgages or auto loans, there is little doubt that consumers were the symbol of the 2008 financial crisis. Since then, households have gone through a painful process of deleveraging, as central banks kept interest rates at rock bottom to help them pay back their debts.
The same isn't true for companies. As monetary authorities edge closer to a world of higher borrowing costs, some fear that companies rather than consumers are planting the seeds of the next crisis.
In its latest Quarterly Review, the Bank for International Settlements has some telling charts on the state of the Western corporate world. Leverage conditions in the U.S. are the highest since the start of the millennium. As the chart below shows, the share of "zombie companies" -- firms whose interest bill exceeds earnings before interest and taxes -- in the euro zone and the U.K. has continued to rise since the crisis, and now stands at over 10 percent.
The "zombification" of the corporate world -- especially in Europe -- matters greatly for economic growth. Zombie companies suck workers and capital away from their more productive competitors, as well as from startups. As Ben Broadbent, a deputy governor at the Bank of England, has shown in a series of speeches, the artificial survival of companies in trouble has been one of the factors behind the stagnation of U.K. productivity. A recent study by the OECD has found that had the proportion of zombie companies been the same as before the crisis, productivity growth would have been significantly higher in rich countries and especially in Spain and Italy.
The additional warning coming from the BIS paper is that the weakness in the balance sheets of corporates could be a threat to future growth and financial stability. This cautionary advice comes at an important juncture for central banks. In the U.K., the Bank of England is edging closer to the first interest rate hike in a decade. The European Central Bank is pondering when and how to reduce its purchases of government and corporate bonds. This week, the U.S. Federal Reserve may announce the first outright reduction in the stock of assets bought since the crash and may follow up with another rate increase in December. As interest rates start to rise, an increasing number of troubled companies will find it hard to pay back their debts, which may lead to a wave of defaults.
This need not be a problem for governments: The exit of unproductive companies is one of the ways to make an economy more efficient and innovative. Politicians should let firms fail rather than providing subsidies to keep them afloat. Instead, the focus should be on ensuring that the financial system is sufficiently resilient to deal with any ensuing shocks. The good news is that banks on both sides of the Atlantic hold significantly more capital than they did before the crisis. Supervisors should continue to monitor the impact that a rate increase could have on the exposure of individual banks, particularly smaller ones. As Warren Buffett famously said, "Only when the tide goes out do you discover who's been swimming naked."
The return to higher rates need not pose a risk. It may, in fact, be an opportunity. A growing economy makes it less painful to tolerate some companies going bust as workers can find employment elsewhere. Banks too can cope more easily with corporate failures, since they can enjoy higher interest rates margin and, overall, see the quality of their credit improve.
Still, the BIS is right to point to overleveraged firms being the new weak link in the financial system. The increase in interest rates will be a test for the stabilizing measures put in place after the crisis. Governments need to trust that they will work, while central banks should not stray from the course.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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Therese Raphael at email@example.com