We have consistently argued that, by giving unprofitable firms a prolonged lifeline, ultra-loose monetary policy has contributed to weaker productivity growth in recent years. New research from the BIS and OECD supports this view; both organisations have found that the share of firms that are unprofitable, or ‘zombies’, has been rising rapidly across advanced economies. The OECD has said that low interest rates may be one of the causes. But what exactly is a zombie? We answer that question in this note.
We have also looked at the earnings of more than 10,000 US-listed companies and, using our own zombie definitions, we have found that the share of US-listed firms that are zombies is high, and rising. In fact, only twice in the last 25 years was the share of all US-listed firms that are zombies higher than it is today: at the height of the dotcom bubble and during the subprime mortgage crisis. To some, this finding should prompt the Fed to halt its rate-tightening cycle. To us, the opposite is true: by raising rates and letting zombies die, resources could be put to more productive use elsewhere.
The premise for our theory that ultra-loose monetary policy is contributing to the productivity slowdown is the following: by pushing down borrowing costs to abnormally low levels for a prolonged period, ultra-loose monetary policy has allowed unprofitable firms to stay in business. Not only are these firms unproductive, but their survival blocks the emergence of younger, more innovative competitors. Expressed another way, we think that low interest rates are stifling the forces of creative destruction. This is reflected by a fall in the corporate failure rate and the corporate birth rate. It turns out that the number of zombies has been rising too, which we will show in the remainder of this note.
What exactly is a ‘zombie’, or ‘zombie firm’?
Conceptually, it can be thought of as a firm that should have died, but has stayed alive for one reason or another. And it follows that the resources taken up by these zombies could be put to more productive use elsewhere.
For the purposes of investigating the presence of zombies in the US economy over the last 25 years, we have settled on two quantifiable zombie definitions — a strict definition and a loose definition — using data which are publicly available for a large number of firms. Both of these definitions use the interest coverage ratio, with EBITDA (earnings before interest, tax, depreciation and amortisation) used as a measure of operating profitability. We prefer EBITDA over EBIT since it is available for a much wider set of firms than EBIT.
Our loose definition defines a zombie as a firm with an interest coverage ratio (i.e. EBITDA to interest expense) of less than one. Under the strict definition, firms are only considered zombies when they have an interest coverage ratio of less than one for three consecutive years. We have only included corporations with annual revenues exceeding US$100 million, in current prices, in order to exclude smaller firms, and firms in their start-up phase, which are more likely to be zombies than larger, more established firms. We have accounted for survivorship bias by including all firms that meet the criteria at the time, even if they have subsequently gone out of business. Our sample includes more than 10,700 companies.
Using our loose definition, we find that the share of US-listed firms that are zombies has risen significantly over the last two years. In 2016, the share was just below 17%. In other words, the operating earnings of nearly one-fifth of US listed corporations (with annual revenues exceeding US$100 million) were insufficient to cover their interest payments last year. This was the third highest share since the beginning of our data in 1992; it was higher only in 2001 and 2009, at the height of the dotcom bubble and the subprime mortgage crisis respectively.
One reason for the rise in zombies over the last two years is the fall in the oil price, which has hit the profitability of firms listed in the energy sector. Indeed, in 2016, the interest coverage ratio was less than one for more than 40% of all energy firms. But the rise in the number of zombies is not just an oil story — the share of non-energy firms that are zombies has also been rising. As the chart below shows, a large share of firms in other sectors, notably information technology and healthcare, can be classed as zombies. In fact, 73% of all zombies in 2016 were in sectors other than energy.
Our second, stricter, definition considers firms to be zombies only if their interest coverage ratio was less than one for three consecutive years. Expressed another way, this definition includes only firms that have persistent difficulty in meeting their interest payments. Using this strict definition, the share of zombies is lower now than it was in the years before the 2008 crisis. Nevertheless, the share of zombies has risen in each of the last four years and at current levels, it is much higher than it was at any time in the 1990s. The results show that in 2016 around five per cent of all listed firms had generated insufficient earnings to meet their interest payments for three consecutive years.
When the aforementioned results are weighted by market cap, the share of firms that are zombies (that is, the market capitalisation of zombies, as a share of the market capitalisation of all listed firms) under both the loose and strict definitions declines. This tells us that smaller firms are more likely to be zombies than larger firms. The results also show that the market cap weighted share of firms that are zombies has risen significantly in recent years, albeit from a low level. In only one year out of the last 25 was the market capitalisation weighted share of zombies higher than it is today, under both the strict and loose definitions.
In light of these findings, it may seem curious that, on aggregate, the US corporate sector appears to be in good shape. After all, according to the national accounts, nominal after-tax corporate profits were US$ 1.7 trillion (in annualised terms) in 2017 Q2, just below the all-time high in 2014 Q4. As a share of GDP, US corporate profits were 8.6% in Q2, well above the long-run average and not far below the peak of 10.1% in 2011 Q4. Meanwhile, the share of firms with negative EBITDA has been rising, even though the median EBITDA margin has been rising. (See charts below.)
There appears to have been a distributional shift in the profitability of US firms. The average US firm is more profitable than it has been in recent years, judging by the median EBITDA margin of the firms in our sample. By contrast, a greater share of firms has negative EBITDA now than at any time other than 2001 or 2009, the peak of the dotcom bubble and subprime mortgage crisis. The paradox is striking: the number of zombies is rising, even though, on aggregate, the corporate sector appears to be in decent shape.
To some, our findings could be considered as a reason for the Fed to halt its rate-tightening cycle. To us, the opposite is true. In order for the economy to return to a more dynamic state, more unprofitable firms need to die; higher interest rates might be one way to tip them over the edge. There may be other ways to get rid of zombies, although for now they are unclear.
Either way, it is important to remember that the Fed’s current rate-tightening cycle is the most benign tightening cycle in at least the last 40 years. Moreover, with tax cuts on the horizon and the US economy creating more than enough jobs every month to absorb new entrants into the labour force, the economy could afford to lose some zombies without falling into a recession. Gradually removing life support for the walking dead does not sound like a bad idea.
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