The zombie Europe. Why is credit not flowing?
“Low rates make banks support zombie zombie companies” Nicolas Véron
Too much liquidity in the wrong sectors.
Almost all the liquidity that flooded Europe with the ECB’s policies went to two sustain zombie sectors: near-bankrupt large companies , which are kept alive artificially, and unsustainable sovereign debt of highly indebted states. It’s Night of the Living Dead, by George A. Romero, in a financial version.
This is a 600 billion euro problem in Europe and some estimate the size at more than one trillion, in a banking sector that exceeds 300% of GDP in the euro-zone.
That is why we cannot build the house from the roof and launch the much trumpeted banking union. It would perpetuate the “pretend and extend” problem, and solve nothing . In fact, risk increases.
What are zombies loans?
I’ve been talking about them since 2007. Think of a business or public administration, large and heavily indebted, which calls for a huge loan at the time of ‘we need to grow and grow’ for a public project or a large acquisition … and when the recession arrives, they can not afford to repay the loan. The bank prefers to refinance the loan because surfacing the is too hard, and therefore prefers to wait until things get better.
What happens? That things do not improve. They worsen. But as rates are low and continue to decline, bank prefer to refinance again.
The perverse incentive to copy Japan with its zombie loans and wait. The country has lived since 1997 with zero interest rates and the risks do not improve. The ball gets bigger.
Once you spend six years in crisis, with everyone holding their breath to see if next year we see growth, four things happen:
- The delinquency rate soars. In Spain, it’s 10.7% despite the bad bank (Sareb) swallowing billions in toxic assets. In Europe, delinquencies also continue to grow.
- The balance sheet of the corporate zombies artificially kept alive does not improve. In fact, it worsens. According to Eurostat, in Spain 40% of listed companies have too much debt and negative free cash flow. The third worst country in Europe in debt repayment capacity.
- As the balance sheets deteriorate, the quality of the loan portfolio of banks gets worse and banks can not lend to good SMEs and households.
- Then, to top it off, as interest rates continue to fall, banks seeking some profitability and “security” …flood their portfolios with sovereign debt, accepting less and less yield, even when the risk increases.
In short, banks deepen their risk exposure, the balance sheets of problematic companies is not cleaned, governments borrow more and the contagion risk of sovereign debt-financial sector-real economy deepens.Meanwhile, SMEs are still suffering.
Of course, many will tell me we need more time, that all cannot be done in a day.But it’s been six years. That’s why financial reform is so important.
This is the perverse incentive of lowering rates again and again. Perpetuating the hole. That’s why moving rates down from 0.75% to 0.5%, or 0% does nothing.
Lowering rates perpetuates insolvent models because it is cheaper than cleaning up balance sheets
If we do not solve the problem of low bank capitalization, the economy will not improve and credit will not flow to households and SMEs.
The Bank of Spain estimates 160 billion of refinanced loans, ie possible hidden delinquencies. It is therefore very welcome to see an initiative to analyse those refinanced loans.
A problem in all of Europe
But it’s worth saying that the capital increase of Deutsche Bank and Commerzbank shows that it is a problem all over Europe, not only Spain. It is the inability of the banks to improve their capitalization organically, that is, through their core business. Capital increases are needed. And what has been done so far is not enough.
According to JP Morgan and Goldman, European banks need at least 34 billion euro to achieve a meager 9% tier 1 core capital, 95 billion, if we include derivative positions.
How not to fix it
It is not solved by introducing more relaxation of the regulations (Basel III). Nor hiding and looking the other way with banking unions, to create a European mess where nobody knows what’s in the balance sheets of others. In addition, the banking union is a process that would lead to years of negotiations, bureaucracy and analysis, as few in the financial sector trust what other banks have in their balance sheets.
It is not solved either by looking the other way and asking that the ECB lends directly to businesses . This creates a huge moral hazard. Why do we have banks? Why have we spent hundreds of billions in bailouts?
Look how curious these perverse incentives are. Spanish banks that have not received bailouts are providing 70% of loans to SMEs and households . And many public savings banks, after the bailouts, not only have not solved their business models, but hardly lend. They are just machines that buy sovereign bonds.
How to fix it
Increase capital, conversion of debt into equity ( debt to equity swaps ) are essential, swiftly but orderly. Avoid another Cyprus using this environment of huge liquidity to recapitalize, because otherwise the hole only increases and the elephant in the room that nobody wants to talk about is sovereign debt … banks are accumulating greater risks by accepting lower returns.
Europe has to attract private financing, venture capital and untie the real economy from banks while they heal their finances. That can not be achieved by keeping the zombies sectors nor through repressive taxation.
Europe cannot pull the chequebook again. Previous stimulus plans and unjustified infrastructure investments have left masses of debt and inefficient and expensive systems. There is no better stimulus plan than to recapitalize banks, through market measures, and to lower taxes.
This means no cost to the citizen and no debt for our grandchildren.
Do not worry, rates will be dropped again. But if Europe does not tackle the problem of liquidity predators – governments and zombie companies-, nothing will change. Perverse incentives to kick the can forward remain the same. The funny thing is that now they say it’s for “the social good”.
It’s funny, when Greenspan in the U.S. brought rates to 1% many in Europe complained warning about the excessive risk that was being accumulated in the economy. And they were right. The funny thing is that today, for the sake of “growth”, European governments demand more debt. When it explodes, the blame will fall, of course, on “the markets”.
This article below was published in El Confidencial in Spanish