🧟 Are we facing a zombie apocalypse? Zombie firms

What are Zombie Companies? Why would anyone finance them? Are the Zombie Firms harmful for the economy?

▪ The problem of zombie firms

We touched upon the subject of entrepreneurship, companies, economic growth and central banks on our channel. Now we talk about a topic that include all this issues – the zombie companies problem.

According to the supporters of the free market, competition between entrepreneurs leads to a favorable allocation of resources in the economy. Entrepreneurs, fighting for the customer’s favor, try to offer the best product at the best possible price for the customer. Customers are the final judges who, with their money, decide which entrepreneurs will earn and which will lose. Those companies whose products people are more likely to buy remain in the market and grow, while the companies whose products people don’t want to buy suffer losses and go out of business.

Competition, together with the profit and loss account, is a market process that not only allocates resources but also regulates the activities of companies. Companies whose products customers want to buy can develop their businesses thanks to the profits achieved. On the other hand, companies that suffer losses, change their business model or fail, and its resources can be taken over by other entrepreneurs who will make better use of these resources. In this way, resources are constantly directed to the best possible use and their unproductive use is limited.

Currently, however, all over the world we observe an increasing number of companies that do not collapse, although they are not able to fully pay their liabilities – the so-called zombie firms. Japan has struggled with these living corpses of business since the 1990s, and the rest of the world has been struggling since the Great Recession of 2008. How is this possible with the economic calculation, that should prevent such a situation?

▪ What are zombie companies?

The term “zombie company”, or “zombie bank” to be exact, was first used by Edward Kane in 1989, who researched the credit industry in the United States. He stated that the cancellation of debts results in the emergence of companies from the dead, but they arise in a state of ominous quasi-life and with their existence haunt other economic entities.

There is no single definition of a zombie company. Often, a zombie company is defined as a company that is unable to repay loan installments from its revenues. Ryan Banerjee and Boris Hofmann, in “The rise of zombie firms: causes and consequences”, define a zombie company as a company that is unable to cover its servicing costs from its ongoing profits over the long term. Meanwhile, McGowan, Andrews and Millot in “The walking dead? Zombie firms and productivity performance in OECD countries” define zombie firm as an old company that struggles to cover its interest obligations.

When a company goes bankrupt, employees are laid off, its factors of production are sold off, and the money from that sale is used to pay off as much of the debt as possible. The rest of the debt will by no means be repaid. It is similar in the case of restructuring – the company may try to renegotiate its loan agreements with creditors and sell off some of its assets to satisfy the creditors. In both cases, resources are released that can be taken over by other entrepreneurs.

Zombie companies are those companies that operate inefficiently and do not pay their debts, yet do not collapse and continue to operate. These companies would normally have to change their business model and undergo restructuring or collapse, and their resources should be taken over by their competitors. However, despite the dire situation these companies find themselves in, they continue to operate by further utilizing resources and hiring employees.

Zombie companies are a problem not only for investors and banks that are now struggling to get their money back, but for the economy as a whole. They contribute to a slowdown in economic growth and productivity for several reasons:

First, zombie companies have low productivity – every working hour involved in a zombie company’s venture creates little value in relation to healthy companies. The same applies to the remaining resources used, the consumption of which creates a low-value product compared to a healthy company.

Second, these firms are pushing out investments by more productive firms because they themselves are still using resources and receiving funding that other firms now cannot get.

Third, zombie companies have a negative impact on resource allocation because they inefficiently use the factors of production, but they are also not allowed to collapse, preventing others from seizing resources.

We remember from our previous videos that factors of production are scarce and we have to decide how to use them. When a zombie company is still in the market for some reason and not collapsing, a smaller proportion of resources can be shifted to better, more productive uses. Since these companies do not collapse when they should, they still use buildings, machines and various materials without generating any profit.

Better, more capable entrepreneurs cannot take over the resources of zombie companies because they are neither restructured nor collapsed. For this reason, productive companies have to pay more for the factors of production than they would pay if the zombie companies did not exist. This means that in the absence of zombie companies, solid companies would incur lower costs and have better access to resources, so they could operate more efficiently.

▪ Why does anyone decide to keep zombie businesses alive?

Two reasons are most often mentioned: the bank’s desire to hide the truth about its balance sheet and access to cheap money.

During the economic boom, banks willingly grant loans to companies. When the boom ends, it turns out that some of the company’s investments financed by the bank are unprofitable, and therefore the company will not be able to repay the loan. Such an unpaid loan is a loss for the bank, and the more wrong investments the bank finances, the greater the loss it is exposed to. Theoretically, the bank should admit that the loan will not be repaid, write it off and introduce changes in its activities, primarily by improving the processes of selection and monitoring of borrowers.

However, banks may try to avoid writing off the loan and instead continue to finance the activities of an unprofitable company that will become a zombie through this bank financing. If a bank has granted a significant amount of credit to unprofitable companies, realizing losses on these loans will involve a painful process of repairing the balance sheet. If the losses are realized, the value of the bank’s balance sheet will decline and it will become clear that the bank is undercapitalized and poorly managed. When information about this reaches the market and regulators, the bank’s market valuation will drop and the costs of obtaining financing by the bank on the market will increase, as this bank will be perceived as risky and poorly managed. On the other hand, regulators will start to interfere with the bank’s operations, ordering it to start corrective actions.

For this reason, the bank will have to reduce its lending, modify its business model and recapitalize. This process takes a long time, during which the bank’s profits will be lower.

We can also mention the profits of the bank’s management board and managers — their earnings and reputation depend on the bank’s condition. The realization of losses means an admission by the management board of poor management of the bank. Their salary and reputation as entrepreneurs will suffer. Bank managers have reasons to postpone the moment of realizing credit losses.

Banks themselves also need to finance themselves, and the more zombie companies they want to keep, the cheaper funding they need. Commercial banks can obtain cheap financing thanks to the activities of central banks. Through their operations, central banks influence the availability of reserves and the level of interest rates in the economy. By lowering the discount, lombard or other rates that a given central bank sets, the monetary authority also indirectly lowers other interest rates in the economy. Thanks to this, commercial banks can obtain cheaper financing on the market or at the central bank. Also, the greater propensity of the central bank to provide reserves reduces the cost of running zombie companies. Quantitative easing also lowers interest rates and helps commercial banks finance zombie companies – in short, this program’s operations create additional demand for financial assets and increase commercial banks’ reserves.

Without a loose monetary policy by central banks, commercial banks could keep fewer zombie businesses alive. The monetary authorities’ drive to support the economy has significantly enabled commercial banks to keep far more zombie businesses alive than would have been possible in an environment of higher interest rates.

▪ How serious is the problem of zombie companies to economies?

Zombie companies can negatively affect economic growth. Countries where there are many zombie companies or employ a significant number of people develop poorly. For example, let’s look at three European countries that are struggling with weak economic growth – Belgium, Spain and Italy. According to economists McGowan, Andrews and Millot, zombie companies in 2013 represented 9%, 10% and 6% of publicly traded companies in 2013, respectively. At the same time, they employed 14%, 12% and 10% of all employees among the companies included in the survey, respectively. At the same time, in zombie companies in these countries, about 15% of the capital of the surveyed companies in Belgium and Spain was drowned, and in the case of Italy as much as 19%.

According to the previously mentioned economists McGowan, Andrews and Millot¹, zombie companies are also responsible for slowing down the dynamics of productivity, understood as a part of GDP growth, which is caused by changes in technology, management, economies of scale, and investment dynamics. Were it not for the presence of zombie companies, the investments of a typical company in 2013 in Spain would be more than 1 pp, and in Belgium and Italy by about 2 pp. On the other hand, the productivity would be 1.4 pp higher. in Spain, 1.2 pps in Italy and 0.3 pps in Belgium.

▪ Summary

The financial sector is still struggling with problems since the Great Recession of 2008 and central banks have been pursuing a very loose monetary policy. For this reason, the number of zombie businesses in economies continued to grow. Ryan Banerjee and Boris Hoffman, cited earlier, calculated that in 2016, zombie companies accounted for over 12% of all companies listed on stock exchanges in 14 developed countries1. Interestingly, as these two economists show, the number of zombie companies began to grow since the 1990s.
2016 is a relatively recent year, and the economic policy until 2020 has not changed significantly, so the problem of zombie companies has probably worsened and solving it may be very problematic for the authorities, as the collapse of these companies threatens to significantly increase unemployment.

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