The Problem with Zombie Companies
- Oxbridge Intelligence
- Oct 4, 2021
- 2 min read
By Kelvin Tai - Economics and Management Student @ Harris Manchester College, Oxford
With a slew of zombie-related film entertainment released in 2021 such as Army of the Dead and Kingdom’s Ashin of the North, it might be time to examine the non-fictional, corporate version. A zombie company is one that lumbers along while saddled with high levels of debt. Such companies may still earn an operating income, but it is only sufficient to pay for the interest on debt and not the principal. The term originated from a paper examining Japan during the “Lost Decade” but is also applicable to European and American firms today.
These zombie companies are reliant on bailouts or government subsidies to avoid insolvency, without which they would be rendered bankrupt. Governments often have an incentive to keep large firms alive, as their collapse would mean large numbers of layoffs that are politically unpopular. They may hence channel taxpayers’ funds towards these companies or compel banks to lend to them. The latter was encouraged by the Japanese government, leading to what is termed as “ever-greening”. While a fiscal stimulus is often deemed the right thing to do in the case of adverse black swan events such as COVID, continuing these payouts beyond the crisis can lead to companies being kept afloat even though their fundamentals are weak.
In a low-interest environment, many companies took on debt and bought back equity. This makes rational sense since the cost of debt is now so much lower than that of equity and the company can bring down its total cost of capital. However, it is mandatory for debt to be repaid, unlike equity, and a downturn in economic conditions can quickly make this high level of debt untenable.
It may seem like a boon to avert massive layoffs by keeping these firms on artificial life support. However, government support can distort the forces of the free market. More innovative startups are unable to gain market share since the zombie company can undercut the market, which discourages investment in this sector. Schumpeter’s theory of creative destruction is hence disrupted. Meanwhile, talent is locked behind the walls of these companies, even though they should originally have been rendered unemployed and hence reallocated by the labour market to efficient startups. Furthermore, zombie companies obscure poor performance by management since their income statements look healthy even with unsustainable operations.
However, the cure to such an economic malaise is not to abruptly cease support to these firms. The resulting collapse of companies and shock to the economy can depress economic confidence and drive a country into a recession. Instead, a gradual drawback of subsidies would be needed for a soft landing of the economy. The rise of zombie companies may seem to be a mechanism to prevent economic shocks but can precede one if handled poorly. As such, a controlled decline is necessary to unwind the effects of previous stimulus without hurting market confidence excessively.
Further reading:
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