Attack of the zombies

This post first appeared in In The Black, 5 Dec, 2017 https://www.intheblack.com/articles/2017/12/05/zombie-firms

Zombie firms – dud businesses that refuse to die despite not being commercially viable – are not only surviving but multiplying, and acting as deadweight on productivity and growth.

In the hit American schlock-horror show The Walking Dead, the sweaty heroes make killing off zombies look sickening but easy, casually shooting, bludgeoning and slashing their way through swarms of mindless goons to get out of trouble.

Alas, that is not how it is proving to be in the real world.

Across the globe, zombie firms live on, creating a headache for competitors and governments.

Here come the zombies

In well-functioning competitive markets, firms are under constant pressure to perform or lose market share and eventually go out of business.

Contradicting that notion, researchers at the Organisation for Economic Co-operation and Development (OECD) and the International Monetary Fund (IMF) have identified a disturbing trend for chronically under-performing companies to survive.

The OECD study found that between 2003 and 2013 the proportion of all European firms that were zombies (defined as older enterprises chronically unable to meet interest payments) almost doubled from 3 to 5 per cent.

Much of this increase has occurred since the global financial crisis (GFC), and the OECD researchers think they know why.

Usually recessions have a cleansing effect, brutally killing off enterprises which are no longer viable so that only the robust survive.

OECD researchers, however, say that the nature of the GFC and the policy responses to it has blunted this process. Thanks to persistent ultra-low interest rates, carrying high levels of debt is no longer the death sentence it once was. In addition, banks are showing greater forbearance in dealing with debtors, and governments have increased business support to protect jobs.

Zombie firms globally

Zombie firms are not just a European problem. The IMF warns that the Chinese economy is also being weighed down by zombie firms.

In its most recent assessment, the IMF found that China could increase productivity by making better use of resources that are going to zombie firms as well as to industries with overcapacity and state-owned enterprises (SOEs).

It is urging the Chinese government to intensify its efforts to reform the economy, including allowing underperforming firms to fail, reform SOEs and reduce over-capacity.

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Low productivity growth

Economists have puzzled over why productivity growth in recent years has been so lacklustre, and particularly why the practices of the most productive firms are not disseminating through industry in the way that they used to.

The OECD researchers believe that zombie firms are a large part of the problem.

By surviving despite using outdated equipment, processes and practices, zombie firms not only drag down aggregate productivity, they also make it harder for new entrants into the market and hinder the efficient allocation of jobs and investment.

Businesses trying to crack markets congested by zombie firms are forced to clear a much higher productivity threshold to compensate for the lower profits they are able to earn because of the inflated wages and lower prices driven by their zombie rivals.

The researchers estimate that investment in productive enterprises would have been 2 per cent higher in Europe in 2013 had there not been an increase in the number of zombie firms.

An IMF working paper on China estimates that getting rid of zombie firms could generate significant gains of 0.7-1.2 percentage points in long-term growth per year.

It says the Chinese government has made zombie firms a key priority in its strategy to address corporate debt vulnerabilities and improve resource allocation, but finds zombie numbers have increased since 2011.

“Implicit guarantees and the government’s desire to support growth encourage these firms to invest excessively, raising already-high leverage while weakening performance on profitability and debt service capacity,” says the paper.

Zombie firms and Australia’s car industry

When the final car rolled off the Holden assembly line in Adelaide in October 2017, it marked the end of a decades-long effort by successive Australian governments to foster a viable local automobile industry, initially using high tariff walls and later by providing billions of dollars of taxpayer assistance.

Professor Roy Green.

For Professor Roy Green (pictured right) University of Technology Sydney innovation adviser, Australia’s car industry offers a cautionary tale of how zombie-like firms can soak up attention and resources at the expense of much more promising opportunities for growth.

The big car-makers, he says, never had a real interest in transforming their Australian subsidiaries into viable, globally competitive operations.

“These companies were controlled by global headquarters which had no particular interest in creating an export-oriented business in Australia,” Green says.

The tragedy of it is that the big car-makers dominated the policy agenda for so long, to the neglect of the potentially much more viable and vibrant components sector.

“If we gave as much attention to them as to the car assemblers, our car industry would be in a much healthier situation,” he says.

Killing off zombie firms in the real world is much more difficult than annihilating fictional ones in the movies, but the experience in Australia, China and Europe shows that allowing them to continue can perpetuate the pain to economies.

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Australian households ‘world-beating borrowers’

When Atlassian co-founder Mike Cannon-Brookes reportedly paid close to $100 million for the Fairfax family home in Point Piper this past week, it helped confirm that housing in Sydney and Melbourne has become seriously expensive.

The world’s longest property upswing (55 years and counting according to the Bank for International Settlements[1]) and a surge of more than 60 per cent in the past five years (notwithstanding a modest downturn in the last 12 months) will do that.

housing-prices.gif

But just how expensive has Australian property become?

One way to look at it is how much buyers have to borrow to be able to afford a home in Australia, and on this front recently-released figures compiled by the International Monetary Fund[2] provide an intriguing insight.

They show that, when it comes to going all-in to buy a house, no-one comes close to Australian borrowers.

In the three months to June, almost two-thirds of all loans (by value) in Australia were mortgages, which is far higher than any other nation for which the IMF has published figures.

Of the 79 other countries, including 23 advanced economies, that provided financial data to the IMF for the June quarter, none had a home-to-total-loan ratio above 46.3 per cent – a figured dwarfed by Australia’s 63.7 per cent.

The huge share of loans that are for mortgages isn’t being driven by more people borrowing. In fact, the number of owner occupiers taking out loans has been remarkably stable over time. In July 2005, there were 55,123 such borrowers. Twelve years later, in July 2017, there were 54,881.

But over that same period, the proportion (by value) of all loans that were for housing jumped from 56.3 to 63.75 per cent. Some of this growth was surely down to more investors getting into the property market. But the biggest driver was likely to be the surge in house prices over that time.

The preparedness of homebuyers to borrow so heavily to buy housing indicates a number of things:

  • a belief that a mismatch between supply in demand in key city markets will persist;
  • that this mismatch will drive house values up in the longer term;
  • that a mixture of fear and greed is at play – fear of being permanently priced out of the property market, and strong desire to grab a share of housing capital growth; and
  • that residential property will deliver better returns than other asset classes (noting that many are exposed to the sharemarket through their superannuation accounts).

The heavy borrowing required to compete in the recent property market has, of course, made households heavily indebted.

Household debt as a proportion of gross domestic product was at 104.9 per cent in the middle of the year, according to the IMF (Trading Economics/Bank for International Settlements reported it was 122.2 per cent)

australia-households-debt-to-gdp.png

Current low interest rates have until now helped households carry this burden without too much distress, and less than 1 per cent of loans are ‘non-performing’. This is a world away from the situation in European countries hit hardest by the GFC, who are still climbing out from under their debt mountains. In Italy, for instance, more than 14 per cent of loans are still considered non-performing, and in Greece the ratio is a disastrous 45.6 per cent.

But the Reserve Bank of Australia, for one, sees, the level of household debt as a risk for the economy.

As a proportion of disposable income, the central bank warns it is high. The slowdown in wealth accumulation from the cooling property market, along with stagnant wages, has the RBA concerned that household consumption – a key driver of economic growth – could be weaker than it expects.

Moreover, others warn that a significant proportion of borrowers will struggle financially as interest only-loans transition into standard principle-and-interest mortgages in the coming year or so.

Against this, the jobs market is tightening, and there are nascent signs that wages are finally picking up.

The RBA’s core scenario is for above-trend growth driven by solid business investment and a gradual improvement in household consumption, which is underpinned by bigger pay packets, more jobs and low interest rates.

But the not-insignificant risks to this outlook posed by high household debt mean the current period of monetary policy stability – the RBA’s cash rate of 1.5 per cent hasn’t changed in more than two years – is set top continue for a while yet.

 

 

[1] https://www.smh.com.au/business/banking-and-finance/bis-says-australias-55year-house-price-upswing-the-longest-in-the-world-20171016-gz1kdc.html

[2] http://data.imf.org/regular.aspx?key=61404589

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Outlook for property prices: lower for longer?

By Adrian Rollins (this story was first posted by intheblack.com on 7 August 2018, at: https://www.intheblack.com/articles/2018/08/07/outlook-property-prices)

What is the outlook for Australian property prices now that the property market has passed its peak? Will house prices continue to deflate in key markets?

For a country used to ever-rising property prices – they have soared more than 370 per cent in the past 30 years – a new reality of shrinking property values and is taking shape.

Since the market peaked in September 2017, the home value index compiled by property market analyst CoreLogic has slid 1.3 per cent, including a 0.2 per cent decline in June 2018.

The searingly hot Sydney market has been hardest hit. House prices there have tumbled 4.6 per cent since the peak.

Nevertheless, so far the damage to balance sheets has been limited. Nationally, longer-term homeowners have held on to virtually all of their capital gains – prices are still 32.4 per cent higher than they were five years ago.

The property market is deflating, but with a gentle hiss rather than a cacophonous bang.

Nervous mortgage holders and aspiring homebuyers nonetheless wonder how long this decline will last, and how ugly it might get.

Applying the brakes to property prices

Part of the answer lies in understanding what pushed prices so high in the first place, and why they have since turned down.

CoreLogic research director Tim Lawless says easy credit and eager investors underpinned much of the increase in recent years. Buoyed by low interest rates and strong capital gains, investors piled into the property market.

By early 2015, the value of mortgages taken out by investors outstripped those to owner-occupiers, many of them riskier interest-only loans.

At one point, almost half of all loans being written were interest-only.

However, the downturn in house prices has not been driven by higher interest rates or borrowers getting into financial distress. Instead, it has been engineered by regulators, says property analyst Pete Wargent of WargentAdvisory.

Worried by the surge in investor borrowing, financial regulator the Australian Prudential Regulation Authority (APRA) in 2014 placed a 10 per cent speed limit on the growth of loans to investors. Three years later the regulator clamped down on interest-only lending, which had been growing rapidly, imposing a 30 per cent cap on the proportion of new mortgages that could be interest-only.

Listen to the podcast: CPA Changemakers: a discussion on housing affordability

Taken together these measures, says Wargent, were “pretty unique” – and effective.

Within a few months of the investor loan cap, borrowing slumped, dropping by almost a third through 2015, and it has continued to decline.

By April this year investors accounted for just 42 per cent of home loans, the lowest proportion since 2012, and growth in investor lending had dropped below 5 per cent, down from a high above 10 per cent.

Interest-only borrowing, too, has wilted. It accounted for more than 40 per cent of loans approved in 2015; by early this year the ratio was less than 20 per cent.

The regulation-driven credit squeeze has dampened housing markets. Auction clearance rates have slumped to less than 57 per cent nationwide, and are the lowest they have been since 2012, according to CoreLogic figures.

APRA released the brakes on investor lending in April but has no intention of relaxing the pressure on lenders, demanding they limit new lending at very high debt-to-income levels, and set debt-to-income levels for borrowers.

Australia: headed for a property crash?

However, the risks already built up in the system are not going away in a hurry.

The Organisation for Economic Cooperation and Development (OECD) has flagged household indebtedness as the economy’s biggest risk. The ratio of total household debt to income has jumped almost 30 percentage points in the past five years to reach 189 per cent in December 2018, and mortgage debt alone was 139 per cent of income.

Although wealth has grown even faster, some who have borrowed heavily may be vulnerable.

University of New South Wales Business School Professor of Economics Richard Holden puts the chances of a house price crash at 30 per cent, most probably triggered by widespread defaults on interest-only loans.

Although Holden says it is most likely that the property market will avoid a collapse, the risks created by more than A$100 billion of interest-only loans are “non-trivial” and cannot be ignored.

The Reserve Bank of Australia (RBA) estimates that each year until 2021, about A$120 billion of such mortgages will convert to traditional principal and interest loans, forcing up repayments by between 30 and 40 per cent.

The RBA thinks most households have enough of a financial buffer to absorb the increase. However, Holden warns that if even just 10 per cent struggle to make their repayments and are forced to sell, that could be sufficient to trigger a crash.

“I’m not really worried about what happens in Point Piper, Double Bay or Toorak,” he says. “I’m worried about what could happen in the western suburbs of Sydney and Melbourne. If there are big forced sales there, then great damage is going to happen to people who can afford it least.”

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Interest rates: the price of money

A sudden jump in interest rates is another risk.

Few expect the official cash rate to budge from its current record low of 1.5 per cent before late 2019 at the earliest.

However, this doesn’t mean borrowers won’t feel some financial pinch.

Wholesale funding costs on international markets are increasing, and already some smaller lenders are responding by pushing up interest rates on selected mortgages.

Lenders including Macquarie, the Bank of Queensland and Auswide Bank have increased rates on variable interest mortgages by an average of between 0.08 per cent and 0.27 per cent, and Lawless expects larger banks will eventually have to follow suit.

Still some life left in the market

Even if the country avoids a default-induced property crash, economists expect that tighter credit standards and the chilling effect of the banking Royal Commission on lenders will force house prices down for some time yet.

Fifteen economists polled by comparison website Finder.com.au tipped that prices in Sydney and Brisbane could drop by as much as 6 per cent by the end of the year, 4 per cent in Melbourne and Hobart, and 2 per cent in Perth, Adelaide and Darwin.

ANZ Banking Group is even more bearish. It predicts prices nationally could fall by 6 per cent from September 2017’s peak to a trough in 2019, including a plunge of up to 10 per cent in Sydney – a view shared by Macquarie Securities. AMP Capital warns they could drop by as much as 15 per cent by 2020.

However, Australia’s status as a destination of choice for migrants may limit the extent of any decline.

The country, particularly its biggest cities Sydney and Melbourne, has been a magnet for immigrants and Australia’s population is growing close to the fastest among developed countries.

Professor Holden says it is on track to expand by 1.6 per cent this year, and all these people have to live somewhere.

With the supply of dwellings set to tighten – building and home loan approvals nationally have both dipped recently – pressure on home prices could again build.

Australia’s seemingly tireless property market might have more life in it yet.

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Australian politics is not broken, but the Liberal Party might be

The Liberal Party’s extraordinary leadership turmoil, and the likelihood that yet another  Prime Minister is cut down before serving out their full term, has many wondering if the political system is broken.

It isn’t.

There is no doubt that the slavish attention now paid to opinion polls, which have assumed oracular status, has made party politics highly volatile, and the position of leaders more precarious.
But what is playing out in gory detail before the eyes of the country at the moment isn’t the breakdown of political machinery, but a fight for the soul of the Liberal Party.
Abbott, Dutton and co. hold the delusion that they are representative of a mythical ‘silent majority’ that ascribes to their vision of a white-bred country. In their world, Turnbull has too much in common with the Left and is leading the country to Gomorrah and the Coalition to oblivion.
There is no doubt that many people, probably the majority, are not particularly thrilled about the current state of affairs. No period is without its challenges, but the sense of uncertainty and apprehension about the future appears heightened at the moment.
Yet relatively few, I suspect, think that the solution is just to shut the eyes and pretend none of it is happening, which is essentially the policy prescription of Abbott and Dutton.
Which brings us to today’s tussle over where the Liberal Party sits, and where it is going.
For years the Coalition has been slowly abandoning the political centre, something the wiser heads in Labor have spied and are trying to exploit.
The politics of migration to one side (bipartisanship on the treatment of refugees has largely neutralised the issue), the Coalition has sought to wind back action on carbon emissions, undermine Medicare, derail public education reforms, narrow Australia’s engagement with the world, drag the feet on child care and pander to the interests of older voters over those of the young.
Turnbull, who was chosen by his colleagues to replace Abbott and stem this rightward drift, has proved himself an inept politician. By pandering to the maddies like Abbott and Christensen rather than staring them down, he undercut his own authority and emboldened them. The dynamic this set in train was always going to end up in tears.
A Liberal split?
The compulsory voting system means that the weight of the national vote is in the centre – only on rare occasions, and in particular electorates, do the extremes gain much traction. Howard understood this. So did Keating, hence his success in beating Hewson by painting him as an economic ideologue and a risk.
If Abbott, Dutton and co. seize the leadership today and try to drag the Coalition even more to the right, they will increase the strain on a party whose unity is already under severe pressure from trying to span such a wide political spectrum.
An outcome of this episode is that the Liberal Party could splinter. In the early 70s, the success of Whitlam-led Labor revealed a shift in the nation’s political centre over the previous decade or so that had been disguised by the dominance of Menzies and the Liberal Party. As the Coalition recalibrated its position, Don Chipp spied a gap in the political centre and formed the Democrats.
If Abbott and co prevail today, some current Coalition MPs may take a leaf out of the same playbook and quit. The Liberal Party could become a rump based in regional Queensland and parts of WA and NSW.
If Bishop ends up succeeding Turnbull, as I suspect is more likely, it would signal that the bulk of Liberal MPs understand that their political future lies in a contest for the centre.
Abbott, Dutton, Christensen and their fellow travellers would then face the stark choice of sucking it up, or finally having the gumption to leave the supportive cocoon of the Coalition and putting the extent of the their electoral appeal to a real test by forming their own party.
My guess is some might follow Bernardi and do the crazy-brave thing, but most are too timid (and smart) and will stay put, because in their heart of hearts they know that their political relevance is likely to be much reduced once they step outside the shelter of the Liberal Party.
If anything, this episode will show the strength of our political system and, in particular, the virtue of compulsory voting.

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