Ten years after central banks unleashed a period of record low interest rates, the central banks' central bank is warning that this may not have been the smartest move.
In the latest quarterly review from the Bank of International Settlements, the Basel-based organization that oversees the world's central banks warned that decades of falling interest rates have led to a sharp increase in the number of “zombie” firms, rising to an all time high since the 1980s, threatening economic growth and preventing interest rates from rising.
Zombie firms are defined as companies that are at least 10 years old, yet are unable to cover their debt service costs from profits, in other words the Interest Coverage Ratio (ICR) is less than 1x for at least 3 consecutive quarters. These types of companies, which first gained attention in Japan decades ago and have since gained prevalence in Europe and, increasingly, the United States. According to a second definition, a requirement for a "zombie" is to have comparatively low expected future growth potential. Specifically, zombies are required to have a ratio of their assets’ market value to their replacement cost (Tobin’s q) that is below the median within their sector in any given year.
According to authors Ryan Banerjee and Boris Hofmann, zombie firms that fall under the two definitions are very similar with respect to their current profitability, but qualitatively different in their profitability prospects, which may be a function of how central banks have "broken" the market. Graph 1 below shows that, for non-zombie firms, the median ICR is over four times earnings under both definitions. As the majority of zombie firms make losses, the median ICRs are below minus 7 under the broad measure and around minus 5 under the narrow one, so this is hardly a surprise.
A striking difference between the broad and narrow zombie measure emerges, however, with respect to expected future profitability, as measured by Tobin’s q. Under the broad measure, the median Tobin’s q of zombie firms is higher than that of non-zombies. That means that investors are optimistic about the future prospects of many of these zombie firms, more so than that for the non-zombies! As this group includes such "tech" and "story" names as Netflix and Tesla, it is easy to see why the market tends to reward the zombies.
According to the BIS continue to steer resources away from healthier parts of the economy, weighing on productivity and economic growth, while stimulating deflation by keeping clearing prices lower than where they should be in the process reflexively acting as a brake to higher interest rates.
While lower borrowing costs should reduce the number of zombie firms, which tend to be less productive than other companies, as their interest expenses are reduced, the offsetting effect is that lower rates also ease the pressure on both the firms themselves and their creditors to clean up balance sheets, the report noted. Lenders then sometimes continue to provide "evergreen" loans to firms that may not be able to pay back.
“Should this effect be strong enough to reduce growth, it could even depress interest rates further,” the BIS authors warned.
Zombie firms took on more debt and disposed of fewer assets after 2000, a trend which continued after the financial crisis of 2008-2009 when the global interest rates hit a record low.
The BIS found that the 10% decline in nominal interest rates since the mid-80s accounts for around 17% of a six-fold rise in the number of zombie companies, although in reality the number may be far higher.
The report also found that once a company becomes a "zombie", it tends to stay that way for longer rather than recovering or exiting through bankruptcy: while in the late 1980s zombie firms had a 60% chance of staying in that condition the following year, the probability reached 85% in 2016. The main culprit, naturally, is low interest rates which have helped these firms stay afloat by reducing their financial pressure to reduce debt.
Another factor is the symbiotic relationship between creditor and debtor: once "zombie" balance sheets are impaired, banks have incentives to roll over loans to non-viable firms rather than writing them off. This implies that weak banks played a role in the wake of the GFC. By inhibiting corporate restructuring, poorly designed insolvency regimes were also at
“Lower rates boost aggregate demand and raise employment and investment in the short run. But the higher prevalence of zombies they leave behind misallocate resources and weigh on productivity growth,” the report notes and adds that "should this effect be strong enough to reduce growth, it could even depress interest rates further."
The record prevalence of zombie firms also explains the sharp drop off in productivity in recent years:
On average, labor productivity and total factor productivity of zombie firms are lower than those of their peers (under both zombie definitions): the distribution of productivity of zombies is clearly shifted towards the lower end, ie to the left.
The zombie firms highlight a “difficult trade-off” for central bank policy, the BIS writers concluded. While lower rates should help boost aggregate demand in the economy and raise employment, more zombie companies means more misallocation of resources. Their survival will also crowd out investment in, and employment at healthy firms.
The zombies may not survive for much longer, however, as another concern has emerged recently.
With rates now rising, starting this year most of these zombie firms will no longer be able to roll over their maturing debt into lower interest rates. As such, as rates ratchet higher, defaults will inevitably increase - as we noted earlier in "Goldman Warns Of A Default Wave As $1.3 Trillion In Debt Is Set To Mature" - and depending on how pervasive the contagion from these isolated defaults becomes, the fallout could have dire consequences for the bond market as some $1.3 trillion in debt is due to be refinance over the next 5 years.