An increasing number of economists and market participants fear the huge debt overhang – and the spawning of zombie companies – that monetary policies have produced in the last decade.
The prevalent view among academic economists focuses on the business cycle, to which the credit cycle is an appendix. “The credit cycle is just part of the business cycle,” asserts Angelo Melino, professor of economics at the University of Toronto, reflecting mainstream views. “It is only one of many shocks that can happen to the business cycle.”
At the C.D. Howe Institute, Associate Director Jeremy Kronick reflects a similar perspective when he says, “It’s hard to evaluate the typical economic indicators. Yes, debt might be high, but then, cash flow or asset value could also be better. After all, the Bank of Canada has increased rates five times since July 2017, and markets have survived; there has been no debt collapse.”
However, both specialists are not blind to the factors of interest rates, monetary policy and debt burdens. “I agree, there is a heightened sensitivity of economic actors to interest rate increases,” recognizes Kronick, as does Melino when he adds, “Central banks have been major drivers of the business cycle in the last 40 years. But financial collapses are rare events. It’s hard to know if things driving the business cycle have changed and could now be more linked to credit cycles.”
Indeed. But studying the financial cycle specifically is the main focus of Claudio Berio, head of the Monetary and Economic Department at the Bank of International Settlements, in Basel, Switzerland. And he believes that the financial cycle is now driving the economic show – though he hasn’t quite demonstrated it yet.
His work identifies two distinct cycles: the business cycle, typically lasting up to 8 years, and the financial cycle, typically spanning 16 years. Sometimes they differ, as in the somewhat short recession that followed the techno bubble burst of 2000, sometimes they overlap, as in the Great Recession of 2008, when the financial collapse exacerbated and prolonged the economic downturn. Today, the financial cycle, still in an expansion phase, is calling the shots.
Central to the financial cycle is monetary policy, which can help heal a recession, or prepare the next one. If it is too accommodating, as we have witnessed for the last 10 years, it exacerbates underlying weaknesses in a paradoxical way. In a 2013 paper, Berio wrote, “The basic reason for the limitations of monetary policy in a financial bust is not hard to find. Monetary policy typically operates by encouraging borrowing, boosting asset prices and risk-taking. But initial conditions already include too much debt, too-high asset prices (property) and too much risk-taking. There is an inevitable tension between how policy works and the direction the economy needs to take.”
Why has the impact of the financial cycle grown in the economy since the early 1980s? Berio outlines three potential causes: financial market liberalisation since that time, inflation-focused monetary regimes, globalisation and the rise of China, that have muted inflationary pressures while still allowing financial booms to build up further without the check of monetary tightening to rein them in.
These theoretical considerations lead to very practical conditions. Before the 2008 crisis, there was an asset bubble in residential real estate, and household debt shot up to historical highs. Today, debt has shifted to the corporate landscape, now haunted by “zombie firms”. Such firms, at least 10 years old, have insufficient profits to cover interest payments on their debt. “In 1987, the probability of a zombie firm remaining a zombie in the following year was approximately 40%; by 2016, it had risen to 65%,” notes Berio, who believes that low interest rates incentivize firms to keep debt levels high.
The low cost of money has also prompted a spectacular rise in total corporate indebtedness, thinks Jean-Pierre Couture, chief economist and portfolio manager at Hexavest, in Montreal, adding that “interest rates don’t need to increase a lot in order to bite into corporations”. A tipping point appeared in the last quarter of 2018 but was quickly blotted out by pacifying central bank announcements.
Rates increases can bite more viciously than ever, claims Couture, since corporate debt is at an all-time high in the U.S. as well as in Europe and China. In the U.S. alone, it has slowly risen from a share of 120% of GDP in 1970 to 280% in 2018. At the same time, the quality of that debt has alarmingly deteriorated: today, nearly 49% of investment grade companies are rated BBB, just a notch above junk status; in 2009, during the crisis, that proportion was 32%.
“A lot of that debt has fueled the phenomenal growth of share buybacks, a bad allocation of capital, that doesn’t go into the productive engine and only serves to gratify shareholders,” says Jean Charbonneau, senior vice-president and portfolio manager at AGF Investments, in Toronto.
All this tremendous amount of debt has been channeled through the also phenomenal rise of collateralized loan obligations (CLOs) that carve out a share of more than 80% in the US$850 billion U.S. collateralized debt obligations (CDOs) market, the financial derivatives products that became infamous during the 2008 crisis.
This CLO market is a big boy institutional game, without retail players, points out Couture. Little understood by mainstream media, this market, presently under the radar, will become the focus of attention when the next recession hits. We are just waiting for the moment when large investors lose their appetite for such instruments, says Couture, because “never before has the possibility to leverage so much depended on the appetite of investors who are fed these CLOs through banks.”
There was a time when officials simply let recessions play themselves out to purge the economy of all its putridity, indicates Couture. Now the real economy depends more than ever on the sensitivity of investors to the availability of credit. To characterise the whole situation, he uses an image that all snow-bound Canadians will understand: “We shovel the snow by piling it up ahead of us.”
