In France there is Renault, in the Netherlands there is KLM and the United States is known for subsidizing Boeing. Many billions have been loaded into corporations to rescue them from a corona downfall. With the FED’s latest announcement to start buying individual corporate bonds instead of ETF’s, even central banks start to step deeper in the shitty junk environment that years of ultra-low interest rates have created.
In the chart below the rise in share of non-viable zombie companies is plotted. The left chart uses defines zombie companies as firms with an interest coverage ratio less than one for three consecutive years and over 10 years old. The right chart defines firms as zombies when they have a Tobin’s q below the median firm in the sector in a given year. The interest coverage ratio is the ratio of earnings before interest and taxation to interest paid. And Tobin’s q is the sum of the market value of equity and liabilities divided by the sum of the book value of equity and debt.
The right chart is somewhat lower because many investors tend to be overly optimistic about the future prospects of these kind of companies. There seems to be more to gain from these companies, while actually these companies are overvalued junky companies and only survive because of the friendly low interest rate environment. This creates a huge incentive for central banks to start buying corporate bonds in order to safe these obviously unsustainable companies. If they would not use their massive QE-measures these companies would go into default, and as the share is rising, the burden will be greater every time central banks extend this endless cycle of liquidity for these non-viable companies. The end is near, and corona may just have popped the bubble. As a second wave of corona cases initiated in the re-opening United States, this bubble might burst sooner than later.
While many companies are becoming dependent of the zero interest rate, they tend to struggle more and more. An increasing amount of companies is issuing new debt in order to replace and finance old debt. These creates a race to the bottom where faulty and inefficient business models do not get stopped simply because interest rates are dropping. Without creative destruction of old-fashioned and unnecessary companies, there is no new ground and market place for new innovate and more efficient companies. Another thing that is keeping many non-viable zombie companies alive is the fact that they enjoy scale-advantages. No, not the classical economics scale advantages where higher production leads to lower average costs. No these scale advantages more and more express themselves in too-big-too-fail scale advantages. Next to these low-interest rates governments start a subsidizing spree to let these companies survive. Both these factors, governmental support and dropping interest rates along with unlimited quantitative easing, create a race to the bottom. Interest rates may not rise again soon and governments and central banks support the companies where interest rates can not drop further.
There are several reasons why this is a bad thing, creative destruction is necessary in order for economies to continue evolving and innovating. Therefore, governments need to be really careful which sector to support and which companies to let go. Strangely, the U.S. government is still pouring billions every year into the oil industry, which seems rather counter-intuitive when also subsidizing companies like Tesla at the same time. The ultimate example is Boeing, the most subsidized company in U.S. history, this company has become the dirtiest kid in town where sloppy finance has resulted in sloppy engineering, with all the known consequences. However, the aerospace technology of Boeing is vital for agencies like NASA, Homeland Security and the U.S. Military.
On the contrary we have KLM and Renault, companies that both have been struggling to attain a large enough market share to be profitable. The Dutch and French government spent even more billions on these companies that eventually would default anyway. The Golden Investor thinks it is a shame that tax payers end up paying for non-viable companies that eventually will break down anyway. The same billions can be used to rescue other more viable companies, to pay unemployment benefits and to subsidize companies that have higher chances of survival in the 21st century. Supporting these kind of companies creates a race to the bottom with other governments who all are supporting these kind of companies. In the end the weakest countries will lose this race, countries like Italy have already complained about this governmental behavior. They are restrained by the strict conditions of their support while other governments splash with money. Support does not work if it results in unfair competition between supported and non-supported companies.
The Golden Investor pledges for strict policies which have to restrain governments to blindly support every business out there. Governments could use this opportunity to steer businesses to more environmentally friendly business models. However, it is of great importance not to destroy productivity and innovation by unlimited and unrestrained support. The economic engine should not stop rolling, however governments need to stop turning the global economy from a Boeing F-15 into a Renault Twingo, because in that case the economy is not going to fly away after corona.
Banerjee, R and B Hofmann (2018): “Corporate zombies: life cycle and anatomy”, Bank for International Settlements, mimeo.