Last week’s publication of the third quarter “Red Flag Alert” * is a useful springboard into Quantitative Easing (QE): the Zombie Economy, the first in a series of posts in which I want to discuss the unintended side effects of the extraordinary policy measures that have staved off economic meltdown since 2008-9.
The above chart (one my current favourites) shows the insolvency rate1 in the UK, using data from Companies House. In my opinion, what is most extraordinary about this chart is how low corporate insolvencies have been since the global financial crisis. Aside from a very small blip in 2009, the insolvency rate has hardly moved from its already very low level in the mid 2000s. Indeed, the only time it has been lower was during the second world war when most of the economy was geared up for war effort. Yet we have just been through the worst recession in decades. How can this be?
The answer is government policy, both monetary and fiscal. The most significant factor has been QE itself. Ultra low interest rates, combined with unprecedented levels of liquidity support for the banks, has allowed many poorly financed companies to struggle on (the zombies) which in the past might have been unable to pay their debts and been forced into insolvency by their creditors. In addition, HMRC’s “Time to Pay” policy has taken a very lenient approach towards overdue tax payments, often one of the main catalysts forcing companies into insolvency.
The macroeconomic implications of this situation are mixed. High levels of corporate insolvencies are painful for the stakeholders involved as equity values are wiped out and employees are laid off. That this has been largely avoided is clearly a positive for the companies and individuals concerned. On the other hand, and as the above chart attests to, insolvencies appear to be a key component of a thriving economy. They are the liver and kidney of the capitalist organism, flushing out unproductive capital and recycling it efficiently to other areas.
It is possible that this artificially low level of insolvencies may be part of the explanation for the UK’s “productivity puzzle” – the apparent inability of the UK economy to generate any productivity growth, which still sits below 2006-7 levels. Capital in the economy is currently being tied up supporting the zombie economy. If some of this capital were to be freed up then overall productivity in the economy might begin to improve, which in turn would drive an increase in real wages.
There is no shortage of catalysts to drive the insolvency rate up from its current low level. A rise in interest rates would expose many poorly funded companies, potentially forcing them into bankruptcy. Government policy could also change, either by becoming less lenient towards late tax payments or by forcing the state owned high street banks to recognise and take losses on more of their bad debts. Somewhat counter-intuitively, a strong economic recovery would also likely push up the insolvency rate. Economic recoveries tend to put working capital strains on weak businesses while creditors are usually more confident in realisation values that they can achieve through an insolvency process.
One company that stands to benefit from any rise in the insolvency rate is Begbies Traynor Group, the largest independent business recovery specialist in the UK2. They have nationwide coverage and focus mainly on small and medium sized companies. The small market capitalisation (£34m) and high insider ownership put it off most investors’ radars, but it is very lowly valued and offers a 6.7% dividend yield. This low valuation suggests to me that nothing at all is priced into the shares for any eventual rise in the insolvency rate which of course would benefit the company and its shares enormously.
The next in this series of posts will look at how QE has adversely impacted liquidity in the financial markets.
* Red Flag Alert is a quarterly publication that tracks the number of UK businesses experiencing either “critical” or “significant” distress. The latest Q3 report shows a fall in the number of companies experiencing critical distress, continuing the trend of the last few quarters. http://www.redflagalert.com
1. The insolvency rate measures the number of corporate insolvencies as a percentage of the total number of businesses in the economy.
2. This is no recommendation to buy or sell any particular security