Goldilocks and the forbearance cycle
22 May 2018
Corporate bankruptcies are highly disruptive. They result in job losses and capital destruction. However, they are difficult to mitigate due to significant ambiguity regarding the factors which drive them. Explanations include structural factors such as weak productivity growth and a loss of competitiveness; cyclical ones, such as corporate margins and global activity; as well as financial variables such as the cost and availability of credit. Our analysis suggests there is a fairly reliable correlation between defaults rates and the business cycle over the long term. Given the current cycle is relatively mature and our recession prediction models point to a low risk of a downturn in the next few years, we expect bankruptcy rates to remain low. However, changes in the financial cycle, particularly as interest rates rise, present a risk to this assessment. Indeed, a growing body of literature has emerged examining the impact of unconventional monetary policy on corporate defaults. Interest rates affect the availability and cost of credit. Furthermore, they affect the value of firms by altering the present value of future earnings. Unsurprisingly then, default rates' sensitivity to output appears to have weakened of late (see Chart 1). The big question is whether a recent rise in rates will result in a reversal? For now, there are few signs that defaults are increasing systematically. However, the acceleration of corporate leverage and frictions in credit markets, such as aborted debt offerings, deserve close attention.
There may be an even more insidious effect from low interest rates. Some critics argue unconventional policies prevented the failure of a growing number of bad businesses. Indeed, the OECD argues that productive capital sunk in ‘zombie’ firms has risen significantly. Furthermore, they argue that the prevalence of firms with weak productivity may explain the developed world’s productivity puzzle. If this is even partly true policymakers have an obligation to act. Unfortunately, higher rates may not simply flush out zombie companies but may also push solid companies into bankruptcy as growth weakens or contracts are lost. Instead, reforms to improve capital allocation and insolvency regimes, such as the tackling of non-performing loans and promotion of better practices in financial intermediation functions, are required.