The delicate art of ghostbusting
- The ghosts in the machine: zombie firms, unable to cover their debt servicing costs with their current earnings, can significantly deplete potential growth. Still, while it is likely that super-low interest rates contribute to the phenomenon, normalising monetary policy without alternative cover – notably from fiscal policy – could be counter-productive.
- Looking through the “number jungle” of the EU’s Green Deal. The “trillion euros” announcement captured imagination, but the actual incremental money is much smaller. While the sense of commitment and urgency is undeniable, more needs to be done, in particular an explicit trajectory on carbon pricing and the emergence of a new asset class representative of the environmental transition.
- The British question: it seems the data flow is spooking the BOE enough for them to ignore the looming fiscal stimulus. We continue to see the issue of regulatory divergence between the UK and the EU as crucial.
Ghosts in the machine: surgically removing zombies
In his landmark critique of negative interest rates in Jackson Hole last year, Larry Summers mentioned the capital and labour misallocation costs the survival of zombie firms entailed. The expression itself – describing firms which cannot cover their debt servicing costs with their current profits for an extended period of time – is due to Caballero in 2008, but we have seen a flurry of papers in the last two years on the subject. In our view, the most striking macro result from this new body of research came from the early 2019 Bank of International Settlement (BIS) paper by Ryan Banerjee, which concluded that each time the share of zombies rises by one percentage point, aggregate productivity falls by 0.3%. Since in Spain for instance the share of zombies rose from 3% to 10% during the sovereign crisis, the damage can be very significant. In any good horror movie, the zombies are individually weak. They defeat the nimbler humans by the sheer force of their number.
The macro damage done by “zombification” could even rise faster than what the mere number of zombies would entail. Banerjee’s paper suggests a change of behaviour in zombie firms after 2001. Before then, once turning into “zombies” they would deleverage faster than the other businesses. After 2001, they stopped deleveraging. This means that they hoard a growing share of existing financial resources.
There is a wide consensus on the reality of the zombification problem and its toxic impact of economic performance, but the debate is more heated on the sources of zombification. Two natural candidates compete: the level of interest rates, and the health of the banking sector. Finding the right culprit has massive policy implications. If the main culprit is the level of interest rates, then the issue lies squarely with the central bank. If it primarily is a by-product of banks’ ill health, then regulation and supervision are better suited to deal with it.
Banerjee’s paper unambiguously finds a more robust case for the former. His intellectual argument and statistical analysis are very convincing. In a static world, low interest rates should decrease the share of zombies by mechanically reducing the debt servicing burden, but ultimately they also incentivise firms to take too much debt relative to their earning capacity. Another, more subtle mechanism goes through banks’ behaviour: in a context of low interest rates banks will me more open to forbearance – granting an “interest holiday” or rolling over loans to fragile firms – rather than “cutting their loss” because the return on alternative lending is low. In concrete terms, it may be better to hold on a shaky loan with a high interest rate when lending to new, “good risk” loans come with a low interest rate. And indeed, Barnerjee finds a strong and robust impact of low nominal and real interest rates on the changes in the “zombie rate”.
Still, banks’ health matters. Credit institutions are inclined to forbearance rather than recognising losses when their own financial health is fragile and using banks’ price-to-book ratio as a proxy Banerjee also finds in some tests a statistically significant impact of banks’ health on zombification, but a much weaker and unstable one. In other words, episodes of bank crisis trigger spikes in zombification, but what is the underlying cause behind the zombification trend is the decline in interest rates. A working paper by the European Central Bank (ECB) finds a more robust relationship between banks’ financial position and zombification (with a different definition than the one used by Banerjee), but even they conclude that it can explain only a third of the process.
What central banks should do about it is not as obvious as it seems though.
First, even if it is clear zombies deplete potential growth, by impairing productivity growth, giving the zombies mercy and killing them for good could deplete current growth. A rise in interest rates which would trigger a shift in lending towards “good risks”, asphyxiating the zombies, could result in a net negative impact on GDP through a spike in unemployment.
Second, raising interest rates to address zombification can be counter-productive for potential growth also. Indeed the overall tightening in financial conditions would make it difficult for young, innovative but financially fragile firms to raise capital, although they would actually contribute positively to aggregate productivity growth. This is a key point very recently made by Bindseil and Schaaf, two ECB staffers.
The fact that monetary policy would be too blunt a tool to surgically remove zombies does not mean we should be complacent and simply “let zombification happen”. The growth in “debt at risk” can be a major issue in case of tightening in financial conditions. This was neatly explored in a recent blogpost by three Banque de France economists. Instead of focusing on how many zombies there are today, which is the usual approach, they looked into how many of them would appear in France if interest rates were to rise by 100 basis points. “Debt at risk” would then rise by 60%. Beyond the obvious financial stability risk that this would entail, this would be consistent with a non-linear response of economic activity to a normalisation in interest rates (some of the “potential zombies” would have to engage in brutal de-leveraging, with the steep contraction in activity that this usually entails).
All this calls for some very delicate surgery when dealing with the “zombification” of the corporate sector. Banque de France is probably showing the way with resorting to a macro-prudential approach (via the capital charge weighing on banks) rather than calling for a tightening in monetary policy. But even a macro-prudential strategy can trigger some adverse consequences for growth.
Through this angle as in many others we are still faced with what is missing in the European arsenal at this stage: a fiscal capacity to “take the burden” away from central banks, providing an “insurance” when such delicate surgery is implemented.
The EU’s Green Deal: looking through the number jungle
The European Commission released last week an outline of its 2020-2030 investment plan to support its ambitious CO2 emission targets. Most headlines focused on the striking overall figure of EUR1,000bn over 10 years. This looks huge even if this would cover only about a third of the effort likely to be commensurate with the emission reduction quantum. In itself it is not necessarily problematic – after all there is no reason why the European mechanisms only should shoulder the transition costs. What we find more concerning is that the actual quantum of new money is significantly lower than what the headline suggest.
Working through the numbers is not an easy task and we highly recommend our readers to take a good look at the excellent dissection of the financial aspects of the project by Gregory Claeys and Simone Tagliapetra from Bruegel. We summarise in Exhibit 1 the main planks of the “Green Deal”, trying to distinguish what is actual “seed money” – i.e. commitments by the various public stakeholders – from “expected final spending” – i.e. what this “seed money” could yield once taking into account various “multiplier effects” often dependent on how the private sector would respond. We also try to distinguish what is incremental money from what is in effect a repackaging of previous announcements/programmes.
Half of the new resources is coming from a reallocation of the EU budget. 25% – EUR500bn over 10 years – will now go to fighting climate change. Note however that in our understanding these EUR500bn are derived from the EU’s budget trajectory in current euros. Assuming a 2% annual inflation as is common practice in European budgetary discussions the quantum would be closer to EUR400bn in constant euros. More fundamentally, in the previous version of the EU budget agreed two years ago, the proportion dedicated to fighting climate change was already set to 20%. So, the true additional commitment on this item stands at only EUR100bn over 10 years. Note finally that most of these 25% come from existing EU programmes: significant components of the Common Agriculture Policy are counted towards the “environmental agenda”, which is obviously questionable.
The same “stock versus incremental” issue applies to the “national co-financing” item, valued by the EU at EUR114bn over 10 years. This is co-financing applied to the entirety of the European environmental projects. But the incremental impact of the shift to 25% of the share of Green projects would only be EUR22bn. In addition there is a bit of double counting in the whole package since some of the components of Invest EU would actually transit via the Just Transition Mechanism.
From a macro point of view, if EUR100bn of the EU budget are effectively shifted towards fighting climate change within an unchanged global envelope, mechanically this reduces resources for the other EU programmes, which is not good news for the overall fiscal stimulus in the EU.
There are actual “fresh resources” – EUR7.5bn for the Just Transition Mechanism, the EUR12.5bn of additional guarantees granted to the European Investment Bank (EIB) to lend to Green Projects and the EUR25bn coming from the carbon emission trading system – but they are fairly small and the Commission’s estimate of their multiplier effect is ambitious.
Some of the aspects of the plan are innovative and appealing. What we find in particular encouraging is the “just transition” focus on mitigating the social and economic consequences of the energy transition made necessary by the fight against climate change. It is a point we have already made in Macrocast: the reluctance of member states to engage is not necessarily the product of an ideological disagreement with the common goal but often reflects the fear of the transitory job losses affecting specific areas. However, since most of the EU financial effort is stemming from the reallocation of its budget, notably the structural funds, for some of those “reluctant countries” – such as Poland – the net inflow of EU resources into their economy may not rise.
To be fair, the Commission is probably making the most of its constrained resources, but we are concerned with some side-effects of communicating on “big numbers” by essentially repackaging existing initiatives. Indeed, this could stoke complacency in other stakeholders, especially member states which may be under less pressure from their public opinion to make their own adjustments in the belief Brussels is doing the job.
More fundamentally, two key items are still missing in the Commission’s projects in our view. First, a clear trajectory for carbon pricing, which would help corporations make informed decisions on their own transition investment. Second, a new asset class/funding mechanism which could meet the demand for Green products by long term institutional investors. For our part we have proposed replicating the European Stability Mechanism to fight climate change, generating front-loaded joint debt issuance, backed by member States’ capital. The European Investment Bank may come up with innovative funding initiatives, taking the occasion of the new capital guarantees they are receiving. For now, they haven’t provided a detailed outline of their projects.
The British question: The Bank of England (BoE) is not taking risks
Post-election euphoria did not last long. True, the message from surveys is not uniformly bleak. The manufacturing PMI fell again deeper into contraction territory in December 2019 but in the services activity moved back to the neutral 50, with some encouraging signals from the forward-looking sub-components. The housing market – always a key indicator in the UK – is showing signs of improvement according to the latest survey by the Royal Institution of Chartered Surveyors. However, the “acquired speed” of the British economy is slow. The latest monthly GDP estimate (for November) contracted by 0.3%, prompting us to revise our forecast for the whole fourth quarter to zero from 0.2%.
Optimists would merely ascribe this weakness to the effect of past Brexit-related uncertainty, which could leave way to some re-acceleration in the months ahead. Still, it seems a rising number of members of the Monetary Policy Committee of the Bank of England are not willing to take chances, and we now expect them to cut their policy rate on January 30th (the last meeting chaired by Mark Carney). This may be surprising given that – based on Boris Johnson’s election manifesto – a sizeable fiscal stimulus is just around the corner. The central bank may be more sensitive to the impact of the negotiations with the EU on the Free Trade Agreement on confidence throughout 2020.
On this crucial point we would recommend our readers to have a look at a short paper by Sam Lowe from the Centre for European Reform. His point is quite simple but effective in our view. The cost in terms of “trade friction” for the UK in accessing the European market will come from the mere possibility to diverge from EU regulation rather than from the actual divergence. Indeed, even if the UK at least initially keeps the same regulation as the EU, the absence of any automatic alignment would in any case trigger some controls on the European side on movements of goods and a higher administrative cost to UK producers. It is only in the field of financial activity – through the equivalence regime – that de facto regulatory alignment would suffice for full access, but the European Commission will regularly review it and equivalence is only granted on a provisional basis, item by item, which will not provide financial firms from the UK much visibility.
A corollary of Sam Lowe’s point is that if the cost of divergence is in the principle and not in the actual change of regulation, then rationally it would make more sense to actually diverge once the principle is agreed (and we know it is a central tenet of Boris Johnson’s view of Brexit). Indeed, actual divergence may help the UK cut deals with third parties (such as the US). The transitory costs though could be quite significant (trade frictions with the EU would be immediate, while the impact of new trade deals would be for later).
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