The US Federal Reserve (Fed), criticised for keeping the Fed funds rate too low for too long, is aware that US companies are not using their additional resources for the intended purpose. Rather than taking advantage of low interest rates to invest in capital assets, many of them have bought back shares and paid out dividends. As the European Central Bank (ECB) continues to loosen its monetary policy, Eurozone companies could be tempted to follow the same path. Low interest-rate financing, which central banks put in place in a context of low nominal GDP growth, disrupts the market’s role in allocating capital.
It was only after the Fed's second round of quantitative easing that loans to non-financial corporations began to grow (left-hand chart). While credit growth reached a solid 7.5% in 2014, it is now losing steam following the move by banks to tighten lending conditions (see right-hand chart). With corporate debt back at pre-crisis levels and the delinquency rate – when payments are more than 90 days overdue – up from 0.7% at the start of 2015 to 1.6% in the second quarter of 2016, banks are now being more careful (see left-hand chart).
But companies have managed to diversify their sources of financing, turning to the bond market more than ever. Corporate bonds now account for nearly 60% of US companies’ debt, versus 51.7% in 2009 (see right-hand chart above). Corporate bond issuance rose by 36% between 2014 and 2015, and so far in 2016 issuance is up 9.6% on the same period one year earlier (see chart below). If new issues continue at this pace, 2016 will be a record year. Companies thus took advantage of the bond market's low interest rates – around 3.5% in September 2016 – to increase borrowing.
A significant proportion of the borrowings was used to pay dividends and buy back shares, two trends that are sharply up over the same years. Yet this practice has been condemned by Ben Bernanke and by some members of the FOMC. At the FOMC meeting of 26-27 July 2016, it was mentioned that low interest rates were meant to stimulate fixed investment in support of long-term GDP growth rather than to encourage share buybacks and dividend payments, which were considered a poor use of resources (“[…]In addition, several [members] expressed concern that an extended period of low interest rates risked intensifying incentives for investors to each for yield and could lead to the misallocation of capital and mispricing of risk, with possible adverse consequences for financial stability.”)
Companies are not investing more in fixed capital because their production capacities have not been fully used in recent years. They have thus little incentive to invest more in machines and equipment. Even today, capacity utilisation is below 80% in most sectors (see charts below). Capital expenditure projects are just not profitable.
Companies have used their resources for two other purposes: to increase dividends first and then to buy back shares (see charts on the next page). Shareholders benefit from both of these actions, as dividends provide them with income and share buybacks boost share prices. Buybacks not only serve to lift share prices, they also improve companies’ earnings per share (since they reduce the amount of shares on the market). In 2015, dividends rose 5.1% and share buybacks were up 1.9%.
The situation in the USA may be instructive for the Eurozone, where companies are increasing debt levels through bank loans and bond issues. Loans to Eurozone companies have been picking up since the end of 2015 thanks to the ECB’s loose monetary policy and to targeted longer-term refinancing operations (TLTRO). In addition, euro-denominated corporate bond issues have risen sharply since the Corporate Sector Purchase Programme (CSPP) was announced in March 2016 (see right-hand chart below).
However, just like in the USA, economic conditions are not ripe for a corresponding rise in fixed investment. Hourly productivity growth in the first part of this year (+0% YoY) is at its lowest level since the Eurozone was created – excluding the period corresponding to the last financial crisis – while the external environment remains uncertain (see left-hand chart below). The lacklustre GDP growth outlook may tempt companies to take advantage of cheap borrowing to boost their share price through share buybacks or to pay dividends rather than investing massively in capital assets.
ECB bank lending surveys in the Eurozone appear to confirm this trend. These surveys provide insight into the factors that affect companies’ demand for credit. The surveys do not have a category called “Financing to buy back shares”, but “Financing for mergers/acquisitions and corporate restructuring” can serve as a proxy for these activities that do not generate fixed investment. We see that banks reported an increase in credit demand for fixed investment in 2015, but that this dynamic already appears to be weaker in 2016. On the other hand, the number of banks that reported an increase in credit demand for mergers/acquisitions and corporate restructuring continues to increase (see right-hand chart below).
As a result:
- Growing levels of debt among non-financial Eurozone corporations, fuelled by the ECB’s monetary policy, could lead to capital being returned to shareholders in the form of share buybacks and/or dividend payments, as has been the case in recent years in the USA (see chart below).
- Yet the scope and duration of share buybacks in Europe may fall short of what has been
seen in the USA, because the European corporate bond market is less developed.