The recovery in Eurozone growth has become part of the synchronised global growth narrative that most investors are relying on to deliver further gains in equities as we head into 2018. However, the “Zombification” of a chunk of the Eurozone’s corporate sector is not only a major unaddressed structural problem, but it’s getting worse, especially in…you guessed it…Italy and Spain. According to the WSJ.
The Bank for International Settlements, the Basel-based central bank for central banks, defines a zombie as any firm which is at least 10 years old, publicly traded and has interest expenses that exceed the company’s earnings before interest and taxes. Other organizations use different criteria. About 10% of the companies in six eurozone countries, including France, Germany, Italy and Spain are zombies, according to the central bank’s latest data. The percentage is up sharply from 5.5% in 2007. In Italy and Spain, the percentage of zombie companies has tripled since 2007, the Organization for Economic Cooperation and Development estimated in January. Italy’s zombies employed about 10% of all workers and gobbled up nearly 20% of all the capital invested in 2013, the latest year for which figures are available.
The WSJ explains how the ECB’s negative interest rate policy and corporate bond buying are keeping a chunk of the corporate sector, especially in southern Europe on life support. In some cases, even the life support of low rates and debt restructuring is not preventing further deterioration in their metrics. These are the true “Zombie” companies who will probably never come back from being “undead”, i.e. technically dead but still animate. Belatedly, there is some realisation of the risks.
Economists and central bankers say zombies undercut prices charged by healthier competitors, create artificial barriers to entry and prevent the flushing out of weak companies and bad loans that typically happens after downturns. Now that the European economy is in growth mode, those zombies and their related debt problems could become a drag on the entire continent.
“The zombification of the corporate sector and banks (is) a risk for future living standards,” Klaas Knot, a European Central Bank governor and the head of the Dutch central bank, said in an interview.
In some ways, zombie firms are an unintended side effect of years of easy money from the ECB, which rolled out aggressive stimulus policies, including negative interest rates, to support lending and growth. Those policies have been sharply criticized in some richer eurozone countries for making it easier for banks to keep struggling corporate borrowers alive.
Talking of realising the risk, as usual the Bundesbank is acting as Mario Draghi silent conscience.
The ECB said in late October it would extend its giant bond-buying program through next September, likely pushing back the date of any interest-rate increase until at least 2019. A small group of central-bank officials opposed the decision, including Jens Weidmann, president of Germany’s Bundesbank. In a speech in September, Mr. Weidmann cited an academic study that concluded a bond-buying program by the ECB in 2012 had helped stabilize banks in southern Europe and boost lending but resulted in more loans to weak companies by the same banks. There was no positive impact on employment or investment, the study found.
The WSJ focuses on two industries with structural challenges, namely retail and shipping, and begins with a company which is an archetypal Zombie, Stefanel.
Italian clothing maker and retailer Stefanel SpA became famous for its knitted coats and cardigans. Many economists, investors and bankers know Stefanel as something starkly different: a zombie company. It has posted an annual loss for nine of the last 10 years and restructured its bank debt at least six times, including several grace periods when Stefanel only had to pay interest on what it owed. After booming during Italy’s post-World War II expansion, Stefanel and its lumbering factories were overwhelmed by Spanish fast-fashion giant Zara and then battered by the economic slowdown that hit Italy in 2008. Stefanel is still alive but staggering. So are hundreds of other chronically unprofitable, highly indebted companies being kept afloat with new infusions from lenders and shareholders, especially in Southern Europe.
As the WSJ goes on to highlight, even the radical corporate and debt restructuring of Stefanel has only reduced its debt by 12%.
Banks restructured Stefanel’s debt even when the apparel maker’s financial problems worsened. The banks continued to collect interest, and some of the loans were repaid, but their decisions not to wipe the debt off their balance sheets meant the banks had less money for healthy firms. Stefanel’s lenders included Banca Monte dei Paschi di Siena, where bad loans peaked at nearly $58 billion in 2016. The Italian government took over the bank earlier this year.
The bank and Stefanel declined to comment. As part of a new restructuring plan, two distressed-debt funds will get a 71% stake in Stefanel by year-end for about $13 million. Giuseppe Stefanel, the founder’s son and company’s largest shareholder, will wind up with a stake of about 16%, down from his previous 56%. Banks owed $125 million by Stefanel will see that decline to about $110 million. Banks demanded that Mr. Stefanel give up control and step down as chief executive as a precondition for approving the turnaround plan, according to a person familiar with the matter. Mr. Stefanel will remain non-executive chairman and “have no control whatsoever,” the person said. Mr. Stefanel declined to comment.
We fear that this is unlikely to be enough to see Stefanel through the next downturn. But it’s not just southern Europe, German banks have been the largest lenders to the struggling shipping industry, where Zombie companies abound. Moody’s estimated that the five biggest German lenders to the shipping industry had roughly $26 billion of distressed shipping loans at the end of last year. This is a ratio of 37% compared with total shipping loans and was up from 28% the year before.
The relationship between Nordeutsche Vermoegen and HSH Nordbank is the example the WSJ cites to show how are keeping companies alive, barely. From the WSJ.
“Some of these zombie companies are getting financed at (interest rates of) 2% because banks are trying to throw good money after bad,” said Basil Karatzas, a shipping-industry consultant in New York…German shipping company Norddeutsche Vermoegen Holding GmbH & Co. KG suffered total losses of $1.1 billion from 2010 to 2015. Its debt quadrupled to more than $2 billion, or almost nine times revenue, from 2007 to 2010. The companthe “Zombification” of a chunk of the Eurozone’s corporate sector is not only a major unaddressed structural problem, but it’s getting worsey hasn’t reported annual results for 2016. In 2016, Norddeutsche Vermoegen got a half-billion euros in debt relief from HSH Nordbank, a German bank that was until recently the world’s largest lender to the shipping industry. According to the shipping company’s financial statements, Norddeutsche Vermoegen made a profit due to “loan forgiveness by the bank.” Norddeutsche Vermoegen and HSH Nordbank declined to comment.
The gravity of the situation has warranted greater scrutiny by the ECB as the article explains. Back in May, the ECB announced on-site inspection for banks with exposure to distressed shipping debt. In a speech earlier this month, Draghi acknowledged the bad debt problem, while lamenting that many banks lack the ability to absorb losses.
“We all know the damage that persistently high levels of NPLs can do to banks’ health and credit growth. And though NPL levels have been coming down for significant institutions – from around 7.5 per cent in early 2015 to 5.5 per cent now – the problem is not yet solved. “Many banks still lack the ability to absorb large losses, as their ratio of bad loans to capital and provisions remains high,” he said.
The ECB faces a Catch-22, pressing banks to address the problem more aggressively not only threatens the banks, but the provision of credit to the broader economy. The WSJ highlights the Morgan Stanley view that a resolution in Italy, for example, will last a decade.
Italian banks have set aside half of the value of their $407 billion in gross problem loans at the end of 2016, according to the country’s central bank. That means the banks would be hit with billions of euros in additional losses if they sell the loans. Many lenders would rather hold on to the shaky loans and hope for the best. The ECB proposed last month requiring banks to set aside more cash to cover newly classified bad loans. The proposal was criticized by senior Italian officials, including former Prime Minister Matteo Renzi.
“If they pass new rules, credit to small businesses will be impossible,” he wrote on Twitter. Some banks in Italy have begun to tackle the problem, including by announcing plans to sell billions of dollars of bad loans within three years. Analysts at Morgan Stanley estimate it will take the country’s banks 10 years to reach the European average for nonperforming loans.
This impressive piece of journalism ends on a thought-provoking note from Portugal which perfectly describes the endless suffering of the corporate “undead” in structurally challenged industries.
In Portugal, a program set up in 2012 by the government as part of the country’s bailout aimed to help heavily indebted companies reach agreements with creditors, avoid insolvency and free up money to invest and grow. In practice, the revitalization program can discourage banks from pulling the plug on battered companies, said Antonio Samagaio, an accounting professor at ISEG-Lisbon School of Economics and Management. The reason: The program allows lenders to take fewer write-downs because debt that isn’t forgiven still is considered performing for accounting purposes. Lisgráfica Impressão e Artes Gráficas SA, one of Portugal’s largest printers, entered the program in early 2013. Banks forgave 65% of the company’s debt and agreed to extend repayments. That helped Lisgráfica to keep most of its workers on the job. Now, though, Lisgráfica is having trouble making its debt payments. The company’s revenue has been hurt by the advertising decline at newspaper and magazine clients. Lisgráfica’s losses are widening.
Of course, at the heart of these structural problems are the failure by central banks to, firstly not create an artificial sense of prosperity via credit bubbles, but secondly, to accept some shorter-term pain for longer-term free-market gain. As Schumpter asserted “The process of creative destruction is the essential fact about capitalism”, but this isn't capitalism.