Yes, a huge wave of zombies is walking towards us and all we can do is throw obstacles in their way but eventually they will reach us!!
Moving past the dramatic opening, lets jump straight to facts. Zombie companies are like hand-to-mouth workers. Their earnings merely cover their running expenses and interest payments. They do not have funds to make principal repayments on their debts or even for expansion or R&D. However, they remain in the market and are in business rather than being taken over or declaring bankruptcy.
The Bank of International Settlements (BIS) has the following criteria to classify a company as a zombie:
- Not a young company: at least 10 years old
- Unprofitable over time: Interest Coverage Ratio < 1 for 3 consecutive years
- Poor future growth prospects: firm’s low equity valuations (ie. Low tobin’s q ratio: market value of firm’s assets to their book value)
These apply to only non-financial companies since the ratios would not make sense for banking companies.
The zombies’ anatomy differs significantly:
- They are smaller companies which feature low productivity.
- They barely expand and are highly leveraged.
- They might issue more equity to service their debt obligations.
- They generally have access to subsidized credit which helps them survive longer.
The Rising Wave
John Authers notes in his Bloomberg article:
“A little more than a year ago, we were worried about a solvency crisis. With so many companies suddenly deprived of their revenue, it seemed only reasonable to fear that a wave of bankruptcies and defaults would choke the banking system, bring asset prices down, and present us with a secondary financial crisis to follow the public health crisis of the pandemic.”
John Authers
Logic dictates that after a recession, spike in unemployment, and slump in GDP, the number of companies going under should have skyrocketed. Contrary to expectations, the bankruptcy rates have since fallen!
A 2020 study by BIS found that :
- The number of zombies rose from about 4% of all listed firms in the mid-1980s to as many as 15% in 2017.
- The share of listed corporations’ assets, capital and debt sunk in zombie firms is lower, at around 6%-7%
Why are they rising now?
The main reason why such companies are able to survive and not declare insolvency is the fall in interest rates in the last few decades. This, on one hand, implies that doomed companies can now refinance their debt at lower costs. Additionally, lower rates also make high-yield deprived investors more willing to lend to riskier companies in order to reap marginally higher returns. These dual-fold benefits of lower interest rate act as brain for the zombies!
Is their death lurking around the corner?
So, intuitively, one might expect a mega wave of bankruptcy coming up in future when the principal repayments become due. This should make bond investors demand a premium for the heightened bankruptcy risk. Again, contrary to our expectations, the spread between high-yield bonds and 5-year treasury bonds have been the lowest since 2007, whose aftermath was the Global Financial Crisis.
Jim Reid, the Head of Global Fundamental credit Strategy at Deutsche Bank, accurately forecasted serious problems for the credit market before the implosion of 2008. This time, he holds the following views:
“The biggest explanation is that, over the last 20 years, the authorities have implicitly and explicitly intervened to lower defaults. Implicitly via huge monetary stimulus lowering rates, and explicitly via larger and larger bailouts. This has driven down funding costs relative to economic activity and made it much easier for companies to survive even at lower levels of economic growth. In short, we’ve moved away from creative destruction and towards an economy with a higher percentage of zombie companies. In the report, we continue to conclude that while this is great for credit investors it’s not necessarily good for long-term economic growth.”
Even the BIS study shows that the amply credit supply is a major reason for this phenomenon. However, if the economy does not recover swiftly, then the debt will become due and all these zombie companies will be in huge trouble. And of course, the ripple effects will be felt throughout the economy!
We do not need a financial crisis to add weight on top of the ongoing health crisis. Authers’ line of thought, based on the fact that default risk hasn’t been priced into the riskiest corporate debts, is that there will be a form of financial repression wherein central banks will force everyone to lend to corporates and government at uneconomically low rates. This will smoothly circumvent the looming problem of bankruptcy that zombies would have had to face in near future.
The book The Power of Creative Destruction puts forth the argument that when weak companies are allowed to go bust, resources are freed up for more efficient usage. However, with the financial repressions, zombie companies’ lifelines are extended and creative destruction is thwarted. This has adverse consequences for the country’s productivity and therefore, inflation.
Inflation
The lower productivity means doing less with more resources and will inevitably result to a higher inflation. It is not a hypothesis and can already be observed in several economies like the US and the UK.
However, the financial markets are turning a blink eye to it. The bond yields, which should have increased, have in fact dropped. Initially, the talk of inflation sent the yields higher. But now, the US Fed has succeeded in convincing the masses that the inflation spike is transitory. This is backed by the reasoning that the spike is due to the bottlenecks in reopening the economy post the lockdown and will soon mellow down to the normal rates. For example, 1/3rd of the inflation in May can be attributed to used cars and trucks alone.
Another point of view on inflation can be noted by juxtaposing it with 2008. Back then, the river of money printed under the Quantitative Easing scheme flowed from the Bureau of Engraving and Printing and into the financial system, where it seeped through to fill in the gaps. This time, however, this stream has been redirected directly into the bank accounts of citizens through government furloughs and business support schemes. This has resulted in a surge in commodity prices, consumer demand, and even rising house prices. Only time will tell whether this will sustain or will the inflation fall back to the lower 2% level set by the Fed.
Kashvi Gandhi 