Old Europe continues to reveal its old problems: Overcapacity, companies in difficulties and an aging population that has more conservative consumption patterns

In this short video we explore the two main risks I see in the current market: China and the Euro.

Daniel Lacalle is Chief Economist at Tressis SV, has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

Images courtesy Google

(Data BIS, Moody’s, S&P)

The Bank of International Settlements (BIS) has warned again of the collateral damages of extremely loose monetary policy. One of the biggest threats is the rise of “zombie companies”. Since the “recovery” started, zombie firms have increased from 7.5% to 10.5%. In Europe, Bof A estimates that about 9% of the largest companies could be categorized as “walking dead”.

What is a zombie company? It is -in the BIS definition- a listed firm, with ten years or more of existence, where the ratio of EBIT (earnings before interest and taxes) relative to interest expense is lower than one. In essence, a company that merely survives due to the constant refinancing of its debt and, despite re-structuring and low rates, is still unable to cover its interest expense with operating profits, let alone repay the principal.

This share of zombie firms can be perceived by some as “small”. At the end of the day, 10.5% means that 89.5% are not zombies. But that analysis would be too complacent. According to Moody´s and Standard and Poor’s, debt repayment capacity has broadly weakened globally despite ultra-low rates and ample liquidity. Furthermore, the BIS only analyses listed zombie companies, but in the OECD 90% of the companies are SMEs (Small and Medium Enterprises), and a large proportion of these smaller non-listed companies, are still loss-making. In the Eurozone, the ECB estimates that around 30% of SMEs re still in the red and the figures are smaller, but not massively dissimilar in the USD, estimated at 20%, and the UK, close to 25%.

The rise of zombie companies is not a good thing. Some might say that at least these companies are still functioning, and jobs are kept alive, but the reality is that a growingly “zombified” economy is showing to reward the unproductive and tax the productive, creating a perverse incentive and protecting nothing in the long run. Companies that underperform get their debt refinanced over and over again, while growing and high productivity firms struggle to get access to credit. When cheap money ends, the first ones collapse and the second ones have not been allowed to thrive to offset the impact.

Low interest rates and high liquidity have not helped deleverage. Global debt has soared to 325% of GDP. Loose monetary policies have not helped clean overcapacity, and as such zombie companies perpetuate the glut in many sectors, driving down the growth in productivity and, despite historic low unemployment rates, we continue to see real wages stagnate.

The citizen does not benefit from the zombification of the economy. The citizen pays for it. How? With the destruction of savings through financial repression and the collapse of real wage growth. Savers pay for zombification, under the mirage that it “keeps” jobs.

Zombification does not boost job creation or buy time, it is a perverse incentive that delays the recovery. It is a transfer of wealth from savers and healthy companies to inefficient and obsolete businesses.

The longer it takes to clean the overcapacity -whcih stands above 20% in the OECD- and zombification of the economy, the worse the outcome will be. Because, when the placebo effect of monetary policy disappears, the domino of bankruptcies in companies that have been artificially kept alive will not be offset by the improvement in high added-value sectors. Policy makers have decided to penalize the high productivity sectors through taxation and subsidize the low productivity ones through monetary and fiscal policies. This is likely to create a vacuum effect when the bubble bursts.

The jobs and companies that they try to protect will disappear, and the impact on banks’ solvency and the real economy will be much worse.

Avoiding making hard decisions from a crisis created by excess and overcapacity ends up generating a much more negative effect afterwards.

Daniel Lacalle is Chief Economist at Tressis SV, has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

Images courtesy Google

(Data BIS, Moody’s, S&P)

Article published at IM Magazine (here).

Now that article 50 has been triggered, there is a lot of speculation about the disasters looming over Britain. However, many experts believe that besides the challenges ahead there are many opportunities to exploit. Daniel Lacalle, Commissioner of the Madrid Region in London explores the path that lies ahead of Britain in the post-EU era and how European regions like Madrid could benefit from it.

Brexit, the process of disconnecting the United Kingdom from the European Union, has been launched. The first thing we must be is intellectually honest and recognize that the estimates of an economic debacle post-referendum have not happened, but the challenges are relevant. Most economic indicators in the EU and UK have been strengthening. Growth and employment generation in the UK have been revised upward by the Bank of England, and investment banks estimate a similar improvement in Europe.

The UK economy continues to grow with a 20bps increase over post-referendum estimates, bringing GDP growth for 2017 to 1.6%. In addition to the recent revaluation of the Pound against the Euro, we have seen a similar improvement in estimates for the European Union, where GDP growth expectations have been revised up to 1.6% for 2017 and 1.8% for 2018. The reality is that all this happens because there was already a very independent framework in the UK and a dynamic economic environment that makes risk much lower, but we cannot forget that there is a risk.

The fact that these concerns and doom expectations have not yet manifested does not mean that risks do not exist, especially in the face of a tense, long, and hard negotiation in which both sides have very different positions. If the European Union is smart, it would use Brexit as an opportunity to strengthen as an area of freedom, flexibility, attractive investment opportunities and global trade.
Exports and imports The 0.4% decreased in UK production experienced in the first months of 2017, was due to a decrease in the pharmaceutical sector of 0.9% mostly caused by the uncertainty about the Trump healthcare plan, not by Brexit.

The UK trade deficit fell to 4.7 billion pounds in the three months leading to January 2017. Exports grew at the fastest pace in ten years in the quarter, reaching a record high, and imports also skyrocketed. Therefore, it is safe to say that the impact on trade that many predicted is nowhere to be seen at the moment. The UK is one of the biggest trading partners of the EU, and it will continue to be.

Contributions
The United Kingdom is the second largest net contributor, after Germany, to the EU budget. That cost will have to be distributed among the other member States. Spain for example, will have to pay around 1 billion Euros more per year.

Immigration
An extremely important topic. Net immigration from Europe to the UK has more than doubled since 2012 -according to a report by Capital Economics-, reaching 185,000 people. Total net immigration has also shot up, reaching more than 320,000 people, compared with a historical average of 150,000 people, according to the British government.

The free movement of citizens and the rights of EU workers in the United Kingdom and those of the British in the rest of Europe will likely be the ace card used to accelerate negotiations. The UK does not want to outsource its immigration policy to the European Union, as it does not have a clear one or exercise leadership in the face of geopolitical challenges. Be that as it may, the days of the free movement of workers are over, and a policy similar to that of the United States could be expected.

Trade
Nearly half of UK exports go to the EU, but of the 28 countries, 26 have huge trade surpluses with the United Kingdom. What does that mean? The EU, country by country, exports more to Britain than it imports. That is important, especially with the country that has the largest surplus with the UK, Germany.

The UK has a high deficit in trade in goods, but a huge surplus in services. All this means that the exit from the single market can have an impact, but that the solution for each other depends on a fast and specific agreement for the United Kingdom.

Financial sector
With the latest data available, the UK exports 19.4 billion pounds per year in financial services to the EU, a surplus close to 0.9% of GDP. This is a big stumbling block. It is not clear if financial institutions will have a passport to operate with the EU or if the financial sector will face limitations. The United Kingdom originates almost 20% of loans for EU infrastructure projects, according to the City report.

Regulation

According to Capital Economics and Open Europe, the cost to the UK of the 100 most expensive rules and regulations of the European Union is 33 billion pounds a year. Excessive bureaucracy and high taxes have limited potential growth and investment in Europe, particularly in the past eight years.

If the European Union does not take the initiative and begins to dismantle the bureaucratic ‘leviathan’ it has built, this cost will be a problem for many countries. However, we must not miss out on the fact that the UK is already one of the leading countries in ease of doing business. Therefore, eliminating unnecessary regulation and bureaucracy is one of the aces up the sleeve of the UK to attract investment post-Brexit.

Foreign investment
The European Union accounts for almost 46% of foreign investment in the United Kingdom; mainly due to the purchases by multinational companies of other British companies. This flow is not expected to be reduced and, of course, could be easily replaced. European investment has already reduced in recent years and has been more than offset by other countries.

The Opportunity for Madrid

Brexit presents many challenges and opportunities, for Spain as a country and particularly for the Region of Madrid, so that it keeps being a driving force for job creation and to attract investment. These are two distinctive qualities of the Madrid Regional Community.

For those businesses and services that want to remain partly or fully located within the EU, a region like Madrid offers an excellent opportunity for growth and diversification. This is a region fully committed to the European Union project, leader in economic freedom and as a business facilitator, which offers a unique combination of quality services and competitive costs.

The Community of Madrid is not just ready for this opportunity, but it is actually waiting for it with enormous commitment and enthusiasm. Madrid offers a competitive taxation and labour legislation that promotes business growth and employment, top quality infrastructure, a gateway into Europe and Latin America, competitive talent, quality of life and excellent public services. With more than 1.7 million square metres of available first class office space in the centre of Madrid, which ranks 2 in the Savills list of available prime real estate.

UK investment into the EU will not likely be reduced due to Brexit. If anything, it will increase, given the opportunity to develop activities within the EU and move part of some businesses abroad.