Why Covid-19 will make it harder to kill zombie companies

VSOMPETITION BETWEEN companies can offer vast rewards to winners, as evidenced by rich lists dotted with space billionaires. The fate of the losers, on the other hand, is a gruesome death. At least it was. A horde of companies has recently emerged that are neither profitable nor doomed to liquidate or take over. These corporate “zombies” stalk the business landscape. This is bad news for the economy. And many more businesses are at risk of zombification during the covid-19 downturn.

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Zombie businesses are not a new phenomenon. Marginal profitable firms featured prominently in Japan’s “lost decade” of the 1990s (see article). They have since gained ground in the rest of the world. According to the Bank for International Settlements (BIS), a club of central banks, nearly one in six listed companies in rich countries could be classified as a zombie as the pandemic approaches, up from around one in 20 in the 1980s (see graph 1). These are defined as companies that do not generate enough income to pay interest on their loans for three consecutive years and have low valuations that suggest a dying outlook.

There is some disagreement about where these undead businesses are focused. the BIS, which focuses on listed companies, finds most in places like America and Britain, estimating that up to a fifth of companies have zombies. But that seems to be because these places have a lot of small businesses listed, and small businesses are generally more likely to be zombies. the OECD, a political team of the rich countries, grabs others, like the less dynamic duo of Greece and Italy. All parties agree, however, that the numbers have climbed in recent decades.

What conditions helped zombies thrive? Much like the living dead from horror movies, unproductive businesses have found ways to stumble despite the lack of the usual vital signs. Banks would once have pushed their bad debts into bankruptcy, perhaps hoping to recover some of their outstanding loans through restructuring, sale or liquidation. Far from playing their role of zombie killer, banks have allowed them, by letting troubled companies repay old loans with new loans.

This may be, indirectly, the result of loose monetary policy: lending money to a poor prospect is less painful if the bank pays low financing costs. Banks with weak balance sheets – often the result of low profitability itself linked to low interest rates – are more inclined to back zombies. Extending new loans and pretending they will be repaid avoids acknowledging losses, at the risk of making them worse.

“Permanent” failed loans, in banking parlance, are particularly appealing if a business’s bankruptcy involves a long and painful process of recovery. Some countries, like America, have effective ways of restructuring bankrupt businesses, balancing the interests of existing creditors, employees, and owners. But all too often, the prospect of years of legal wrangling – resulting in little remaining value – means standing still and hoping the business in question somehow recovers is the less bad option. This is especially the case with small businesses, which are therefore much more likely to be zombies.

Keeping struggling businesses going may seem like no problem: a business doesn’t have to be making a profit to keep paying its employees. But the increase in the number of zombies coincides with broader signs of undermined economic vitality. As fewer companies left the markets, fewer companies were also created. Young companies hire fewer workers. Employees move less, even though technology makes it easier for them to find new jobs. Studies suggest that zombification harms economic dynamism in several ways.

Zombified companies invest and innovate less than non-zombies. Worse yet, in some cases zombie businesses seem to be crowding out healthy businesses. Economists of the OECD found that productive firms in zombie-laden industries have a harder time attracting capital. Non-zombie margins are being squeezed by companies that simply do not get a return on their investments. Healthy companies therefore invest less. A one percentage point increase in zombie share translates into a one percentage point drop in non-zombie capital spending, according to the BIS. In turn, productivity growth declines by 0.3 percentage point.

Zombification could also have consequences for competition in the market. Several studies have shown an increasing range of productivity performance among companies in the same industry. The dispersion isn’t just due to superstar companies shining brighter. Studies suggest that latecomers have also stagnated because they have been unable or unwilling to adopt best practices. Markets are less contested and over time provide poorer service to customers.

All of this means that a further rise in zombie businesses could be a nightmarish prospect. Covid-19 will swell their ranks. Companies will see their profits decline as a result of the global recession, but two factors make the conditions appear ideal for zombification: easier access for companies to credit; and attempts by governments to freeze the incumbent economy during the pandemic.

Take credit first. A lending frenzy in recent years has meant that more loans have been issued without restrictive covenants – covenants which, if breached, allow creditors to have a say in how a business is run. Almost all euro-denominated leveraged loans, for example, were “covenant-lite” at the start of 2020; in 2013, less than a tenth were. Even if banks and other creditors wanted to push unprofitable companies to restructure or liquidate, they do not have the power to do so.

In addition, the amount raised by high yield bonds, issued by companies with repayment prospects of the ropy, has risen sharply in recent years. This has offered businesses a cheap way to continue to fund themselves while hoping for better times. Fears that the credit market will dry up with the turnaround in economic conditions have so far not materialized, perhaps thanks to the Federal Reserve’s emergency support for these more dodgy “rotten” bonds. High yield issues soared in the first half of the year (see Chart 2). The $ 292 billion raised in America in the first eight months of 2020 exceeds the amount issued in 2019.

Government measures to protect the economy from the worst of the pandemic may also contribute to an increase in the number of zombie businesses. Absenteeism plans that cover the payroll and state-guaranteed loans that provide liquidity keep unprofitable businesses going. Some politicians have relied on banks not to exclude businesses. Many countries have thrown more sand into the gears of creative destruction. In March, Germany allowed companies upset by covid-19 to defer filing for insolvency. Australia has made it harder for companies to go bankrupt. In India, the central bank allowed lenders to defer recognition of bad loans even as they accumulated, reducing pressure on bankers to accept defaulting borrowers.

The worry now is that the zombies of the Covid era will pile on top of the older ones. There may already be evidence of such an accumulation. Bankruptcies in 2020, in a dire state GDP numbers, is expected to increase by 20 to 40%, depending on the BIS. But in many countries, they are actually lower than before the pandemic (see Figure 2, right panel). Credit markets suggest no hikes are expected.

As economic conditions improve, some zombies will undoubtedly come out of their daze. History suggests, however, that it is not easy. The likelihood of remaining a zombie from year to year has steadily increased. Even resurrected zombies are problematic. Many relapse. Businesses that were zombies in 1995 had a 5% chance of falling back into the living dead state, estimate BIS researchers, pretty much the same as other companies. Now the probability is 17%. Even those who don’t relapse remain weak, with lower growth in earnings, productivity, investment, and employment compared to non-zombies.

Zombie apocalypse

How then to tackle the potential hordes of corporate undead? In Japan, a consolidation of the banking sector in the 2000s led to a rapid decline in unproductive businesses. The good news is that the zombie share has fallen in part because companies have made more profits rather than going bankrupt.

The current global recession makes an immediate recovery in profits unlikely. So instead, you might think the downturn should wipe out unproductive businesses. But this assumes that lenders can cope with credit losses and will not try to avoid write-offs. The weak banks during the 2007-09 financial crisis did little to kill the zombies. This time, emergency support measures, if not reduced, will delay the necessary cleanup.

A threat to the zombies would be a change in the willingness of investors to endure mediocre returns. So far, bankers and markets have been accommodating. But a hike in interest rates, even if not expected anytime soon in the rich world, would be much more painful in a zombified economy. In horror movies, finishing a zombie is a bloody affair. The same is likely to be true in business.

Editor’s Note: Some of our covid-19 coverage is free for readers of The economist today, our daily newsletter. For more stories and our pandemic tracker, check out our hub

This article appeared in the Finance & Economics section of the print edition under the title “The corporate undead”


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