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Joseph Schumpeter shocked many with his forthright views about the power of free markets. The early 20th century Austrian economist once told his students at Harvard University: “Gentlemen, a depression is for capitalism like a good, cold douche”. He was, of course, referring to the forces of creative destruction that drain away weak enterprises during a downturn — and the term for shower. Right now, while a depression is not on the cards, higher interest rates are straining economic activity and a wave of corporate insolvencies are expected. After a decade of rock-bottom rates a Schumpeterian cold shower may not be a bad thing.
Corporate bankruptcies in America are on course to hit their highest level since 2010. Insolvencies have already reached a post-financial crisis high in England and Wales, and have surged in the eurozone too. Allianz forecasts a rise in insolvencies in advanced economies in the next few years, as more businesses refinance on to higher rates. Indeed, in the coming five years, over $3tn of corporate debt is due for repayment in the US.
This should come as no surprise. Interest rates have risen at their fastest in four decades, the labour market is cooling and demand is set to slow. Companies are eating into their cash reserves, and could be in line for a significant step-up to their borrowing costs. Energy bills have soared, post-pandemic government support has waned, and repayments have also come due.
The hit to businesses, and workers, is the cold reality of higher rates. In the long run, however, it could be positive for the economy. Part of the rise in insolvencies is a catch-up effect. Many companies that fold are likely to have been propped up by Covid-19 policy measures, and would have collapsed in any case. Zombie companies — which include enterprises that are in financial distress and persistently unprofitable — will be pinched too. These businesses proliferated in the era of low rates that followed the global financial crisis: their share of listed companies globally rose 4 percentage points to 10 per cent in 2021, according to an IMF working paper.
Zombies sap economic productivity by lowering investment and employment for more efficient businesses. To the extent that the coming quarters of high rates and low growth act as a Darwinian winnowing, sifting out weak companies, bankruptcies should not be feared. But that does not mean the process is without risk.
First, a zombie apocalypse, where the collapse of weak companies spread to larger and more efficient ones in the supply chain, would be problematic. Second, private capital markets have stepped in to support companies, where leverage exposures are harder to gauge. Third, many inefficient companies could survive. Some refinanced before rates shot up and locked in cheaper debt for longer. Key elections next year could also mean government appetite for support remains.
So far, the strains are concentrated in the most highly leveraged enterprises in the retail, healthcare, real estate, and construction industries. In the UK, small businesses — which have fewer systemic implications — are reporting a higher risk of insolvency than larger companies. Regulators still, however, need to boost their monitoring of private markets for any knock-on risks. And above all, restructuring and insolvency services need to be prepared to ensure companies can fail well, and fast. The longer it takes, the greater the strain on businesses and the economy. Retraining and job search support will also help unemployed workers find new roles.
As for the zombies that survive, if rates end up settling higher in the long run — particularly compared to the past decade — then capital will at least begin to flow more towards the best businesses. With start-up activity still buoyant, that is something to embrace, not fear.
Source: Economy - ft.com
