A Market Zombie

Market Zombies: The Cost of Cheap Debt

By: Louis Portail

As central banks across the world scramble to slash rates and buy treasuries in an attempt to stave off an impending economic recession, little thought is paid to the effect cheaper debt will have on companies that are already highly leveraged. Even less thought is paid to debt-laden companies that never turn a profit. This relatively recent generation of companies labelled ‘zombie’ for the fact they continue to operate in low-interest-rate environments despite being virtually insolvent, weighs on global economic performance by lowering investment and employment in more productive companies. Importantly, zombie companies would otherwise collapse in the face of drastically reduced cash flows from the coronavirus crisis. However, with rent forgiveness programs, salary subsidies, and near-zero interest rate credit facilities, zombie companies appear to face a prolonged period of existence off the back of the crisis. While reducing the cash-flow strain and subsequent risk of default for businesses is important to keep an economy ticking during a crisis, ignoring the risk that zombie companies pose to a post-crisis economy is counterproductive.

What defines a zombie company?

The formal definition according to the Bank for International Settlements (BIS) is a company that is listed, has been in existence for more than 10 years and has had an interest coverage ratio of less than one for at least 3 consecutive years. More generally, a zombie company is a firm that requires additional debt to cover debt servicing costs over an extended period of time, or that only generates enough cash flow to pay interest without ever reducing the principal.

Income statement of zombies
Income statement of zombies

Zombie company income statement

The origins of zombie companies

The term zombie company has its origins in a study on Japan’s ‘lost decade’, notably the effect of lax banking regulation during the 1980s and the subsequent flow of credit to borrowers that were otherwise insolvent. Banks that wanted to call in a non-performing loan would have to write off existing capital and risk breaching their minimum capital requirements. As a result, they would continue to lend to insolvent borrowers, banking on the borrower to recover or the government to bail them out. To avoid public criticism that banks were denying credit to businesses during a recession, the Japanese government encouraged banks to increase their lending to SMEs. This gives rise to the theory that bank health is correlated with the prevalence of zombie companies; banks with impaired balance sheets have incentives to roll over loans to non-performing firms. In the early 2000s, more than 30% of Japanese borrowers were zombie companies.

Bank health and zombies
Bank health and zombies

Source: The rise of zombie firms: causes and consequences

The rise of zombie companies

The prevalence of zombie companies has grown significantly in recent decades; BIS estimates across 14 advanced economies, the proportion of zombie firms grew from 2% in the 1980s to 12% in 2016. Further, the probability of a zombie company remaining a zombie in the subsequent year was 60% in the 1980s and 85% in 2016. The most obvious explanation is that low-interest-rate environments reduce the pressure on zombie firms to reduce debt or scale back activity. Additionally, low-interest rates lower the opportunity cost for banks that bet on the resurgence of non-performing firms by loan forbearance.

Interest rates and zombies
Interest rates and zombies

Source: The rise of zombie firms: causes and consequences

The dangers of zombie companies

While zombie companies may appear innocuous, they have a detrimental effect on the economy. Typical competitive outcomes in a functioning market would see zombie companies either improve productivity or lose market share, employees and ultimately collapse in bankruptcy. However, the availability of cheap debt, particularly SME support policy initiatives during and after crisis periods, has seen zombie companies continue to operate and grow in number. The most significant consequence of zombie firms is weakened economic performance as a result of ‘congestion’ effects; zombie companies crowd out investment and employment growth in more productive incumbent firms, deterring new entrants and stifling competition. The increase in post-GFC zombie companies is associated with a 2% cumulative loss in investment and a 0.7% loss in employment across the OECD average. The UK which experienced a decline in zombie companies, largely due to different insolvency proceedings, saw an increase in investment of 1.5%.

Cumulative investment and employment of zombie firm
Cumulative investment and employment of zombie firm

Source: OECD calculations based on ORBIS

Evidence from the BIS suggests that a 1 percentage point increase in the number of zombie firms in a sector is associated with a 1 percentage point decrease in capital expenditure among non-zombie firms (17% reduction on mean investment rate). Similarly, employment growth falls by 0.26 percentage points among non-zombie firms (8% reduction on mean employment growth). Lastly, an increase in zombie firms by 1% results in an economy-wide productivity growth decline of 0.3 percentage points.

Zombie companies today

The Bank for International Settlements estimates that 12 per cent of all listed companies globally are zombie companies and KPMG estimates that one in seven UK companies are zombie companies. While Reserve Bank of Australia governor Philip Lowe says he doesn’t see any examples of zombie companies in Australia, using the definition from the BIS, 17 per cent of the ASX were zombie companies in 2018, an increase of 57 per cent from 2010.

Share of Zombies on ASX

Research conducted by KPMG found that mining, oil and gas sector companies accounted for 70% of zombie companies on the ASX. Many of these companies are exploration companies in the oil and gas, mining and materials sectors. Companies in these sectors typically rely on capital raisings via equity markets, with only 21% of mining companies carrying net debt. This means their aggregate probability of default is low, given the majority of Australian zombie firms do not rely on debt financing. While this may be reassuring, KPMG found that 46% of analysed companies showed an increase in default probability.

The effect of QE on zombie companies

Currently, the average Australian company only holds enough cash on its balance sheet to stay liquid for a month, after which it will have to tap credit lines provided by the major banks or issue new debt. While the market is currently skittish towards new issuances, if central banks are successful, credit growth will be driven by companies refinancing debt at lower rates, increasingly levered on the back of falling profits. This poses a risk to investors, namely retirees and super funds, which predominantly rely on bonds for income, as companies would not be able to maintain operations without monetary easing, which reduces the cost of capital.

This raises the following questions: What will be the impact of easy monetary policy on the presence of zombie companies in Australia? Will decreased appetite among investors see Australian zombie companies unable to raise equity capital? Will we see a rise in their share of the market as they get propped up by increased credit facilities? Will government efforts to reduce the economic impact of the coronavirus crisis be impeded by zombie companies’ dampening effect on productivity?


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Other Related UNIT Articles:

On the Fed’s response in the 2020 COVID-19 pandemic, see ‘The Everything Stimulus’.

Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.

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