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Rising interest rates - a cure for the financially unfit

Investors should welcome rising interest rates – they cause pain, but they also kill off uncompetitive firms.

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Steer clear of overindebted zombie firms

Investors should welcome rising interest rates they cause pain, but they also kill off uncompetitive firms

In zombie stories, the explanations given for the sudden appearance of rampaging flesh-eating hordes vary wildly, from black magic to passing comets to government-funded bioweapons.In real life, the root cause of today's plague of corporate zombies is far more mundane it's mostly down to low interest rates. But like a fictional wave of the undead, these zombies chew up resources, damaging the wider economy.And the bad news is that their numbers have grown sharply in the last few decades.

We look in more detail at the exact definition of a zombie company in the box below. But put simply, a zombie company is one that really should be bankrupt. It has no prospect of making any profit, it's usually heavily indebted, and in a more competitive environment it would long since have been put out of its misery. The Bank for International Settlements (BIS) sometimes known as the central bank of central banks looked at the prevalence of such companies over time. What it found is that, drawing data from across 14 advanced economies (including the UK and the US), the percentage of companies classed as zombies rose from 2% in the late 1980s, to 12% in 2016. While there are a range of factors involved, by far the most statistically significant, says the BIS, is low interest rates.

So why, exactly, are zombies a problem? It's all about resources. These companies are less efficient than other firms (otherwise they wouldn't be zombies). In a more vigorous economy, they would be competed out of business. Instead, they remain in the market, which does two key things: it contributes to an oversupply of goods in a sector (which depresses prices) and it results in the hoarding of resources from capital to labour that could be used more productively by more efficient players (which drives up costs and results in firms cutting back on investment). In turn, that renders the entire economy less productive than it otherwise would be. In effect, these companies are parasitic.

Moreover, warns the BIS, while these firms thrive in a low interest-rate environment, they also, by weighing on productivity and economic growth, help to create the very economic conditions that encouraged central banks to keep rates low in the first place. In other words, low interest rates can easily become a self-fulfilling prophecy by undermining the productivity of the economy. As Nicolas Rabener of FactorResearch points out, this would certainly help to explain some of Japan's woes over the past three decades. So while rising rates will be painful, particularly for investors in overindebted zombie firms, we should be glad. The consequences of keeping them lower for any longer could be even worse.

The Bank for International Settlements (BIS) looks at a number of criteria to define a zombie company. Firstly, it has to be reasonably mature young companies are often loss-making or unprofitable, but that's because they are at the "invest and build" stage of their development. Secondly, it won't have made any profit for an extended period of time, and nor does it show much sign of making decent profits in the foreseeable future (ie, it hasn't been hit by temporary issues, such as restructuring).

Being more specific (and these measures apply only to non-financial firms, as the ratios make no sense if applied to banks, say) identifying features of a zombie are a company that's at least ten years old, and has had an interest coverage ratio of less than one for at least three years in a row (in other words, its earnings haven't even covered the interest payments on its debts).

The rise in the proportion of zombie firms out there, says the BIS, "has been driven by firms staying in the zombie state for longer, rather than recovering or exiting through bankruptcy". In the late 1980s, the chances of a zombie company still being a zombie the following year were already quite high, at 60%. But by 2016, that percentage had leapt to 85%.

Banking crises are one factor in nurturing zombie firms. When banks themselves are bust, they do not want to have to write off loans to companies that can't pay them (and thus reveal that their own balance sheets are badly compromised), so they roll them over instead. That means zombies are under less pressure to sell assets to pay off their debts, which exacerbates resource misallocation. At the same time, the banks make credit harder for young, potentially more successful companies to come by, making things even worse. But, primarily, low interest rates are to blame partly because they encourage lenders to take on more risk, and partly by making it easier to refinance.

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