Compass Money: The Living Dead – Widespread COVID-19 bailouts may swell the ranks of zombie companies

Following massive COVID-19 bailouts, zombie companies may become even harder to kill. (Pxfuel)

Halloween season may be over, but a frightening sight still looms on the horizon. The number of zombie companies—unprofitable businesses kept afloat through external (usually government) support—may be swelling as COVID-related economic policies pile up. While many stimulus packages, furlough schemes, and loan-easing mechanisms have enabled countries to weather the immediate economic ramifications of the pandemic, such measures may inhibit economic growth in the longer-term. This may present problems not only to national economies, but to the global economy as a whole.

Building Cemeteries

The term “zombie company” was coined in 2006, following Japan’s low growth in the 1990s, to describe companies that only generated enough revenue to pay the interest on their debt and not the principal. Japanese banks, unwilling to recognize losses, continued to allow the flow of credit to unprofitable and insolvent companies, leading to the promulgation of companies kept alive only through external aid.

Japan has since handled the situation of such zombie companies, but most of the developed world has struggled. In a report from the Bank of International Settlements, the share of firms in developed countries with profits insufficient to cover interest payments grew from 4 percent in the 1980s to 15 percent in 2017. In the U.S. alone, corporate debt reached $6.5trillion in 2019—almost double the $3.3 trillion in 2008. 

Many conditions have helped zombie companies thrive in recent years. “Evergreening” bad loans—using new loans to pay off previous loans that risk being left unpaid—is a decision that banks and governments prefer if the alternative is letting unproductive companies die and then enduring a long and painful recovery afterwards. Evergreen loans, coupled with shaky monetary policy, also make ailing companies more eager to load up on debt. Such was the case following the 2008 financial crisis, as the world’s major central banks slashed interest rates to zero or lower. 

Economists generally agree that zombies limit competition, reduce productivity, and inhibit growth. What’s more, with soaring debt and ever-heightening risk, widespread loan defaults by zombies may plunge the global economy into a crisis similar to 2008.

Digging Graves

While the rise of zombie companies has been a growing trend, COVID-19 may exacerbate it even further.  The pandemic, and the resulting attempts by governments to resuscitate national economies, provide ideal conditions for the zombification of more firms—while making existing zombie firms even harder to kill. 

How? First is the easing of access to loans issued without covenants—clauses which would allow creditors to impose repercussions (such as restructuring or liquidation) for non-compliant firms. Second is widespread government extending of furlough schemes which subsidize wages. These policies, while feebly propping up many economies, provide lifelines for would-be zombie firms.

Germany, whose economy has been relatively resilient amidst the pandemic, is a prime example. Its job retention program, Kurzarbeitergeld, has been imitated throughout Europe. However, while it has spurred a more robust economic recovery than the rest of the region (limiting rise in unemployment while maintaining consumer spending), the program does not seem beneficial in the long term. Many fear that it could hinder the redeployment of capital and labor to more productive uses.

In addition, commentators warn that the premature deployment of aid may be propping up firms that were struggling even before the pandemic. Additionally, aid given to industries heavily-impacted by the pandemic (e.g. travel, music promotion industry) may be in vain, as COVID-19 may cause long-term structural changes to these sectors. 

As the debt bubble grows in a more interconnected global economy, governments and banks must be wary of how their actions may affect overall economic growth. At the core is the trade-off between short-term or long-term economic growth. Should governments extend huge sums of aid to support zombie companies reeling from the pandemic? Or should governments let ailing companies fail to pave the way for renewed economic vitality in the long run?

Perhaps the answer is to tackle both problems simultaneously—there is no silver bullet.