The return of the zombies: Will they survive?
Zombie companies are back. That’s the view of Valerio Ranciaro, Director General of SACE SRV and Cinzia Guerrieri, Economist at SACE, in the first of a regular series looking at vulnerabilities emerging from the build-up in business leverage after the pandemic and at how long zombie companies can survive
One year after the COVID-19 shock and the first ‘great lockdown’, the world economy is back on a growth path. According to recent estimates by the International Monetary Fund (IMF), global GDP is expected to increase by 6% this year, fully rebounding from the deep recession in 2020 (-3.3%), driven by the US and China. However, the recovery will be uneven and divergent across economies and sectors, with some countries (such as in the Eurozone) and segments (such as contact-intensive services) that will need more time to get back to their pre-crisis levels. Moreover, the race between vaccines and mutations of the virus is not over yet and downside risks to the world economic outlook remain, mostly related to the evolution of the pandemic.
So far, the global financial system has been resilient. Thanks to the lessons of the 2008-09 Global Financial Crisis (GFC), the fiscal and monetary authorities have responded to the crisis in a massive, timely and coordinated manner, both in advanced and emerging economies, sustained by more effective macroprudential policies. Amid easy financial conditions, fiscal policymakers have provided extraordinary support to households and business, especially to those most affected by the restrictions, calming down the liquidity pressures rising from reduced revenues and cashflows. In particular, the measures to sustain the flow of credit to firms include both direct fiscal support and government loan guarantees, alongside legal interventions with moratoria on debt payments and temporary changes to insolvency regimes.
The moratoria have contributed to contain payment defaults, which would have hit capital directly and reduced lending appetite, especially in bank-dependent countries.
Nonetheless, global debt reached a new record of $281 trillion in 2020, corresponding to 355% of GDP, reflecting mostly the sharp increase in sovereign and corporate indebtedness.
Upcoming risks to global financial stability
What potential risks to global financial stability are coming from the build-up in business leverage? We have identified two main sources of vulnerabilities: (i) solvency stress and (ii) zombification.
Solvency stress concerns the deterioration of firms’ balance sheets. While the unprecedented policy support has resulted in a fall in bankruptcies during the pandemic in advanced countries, insolvencies could still rise significantly in 2021-2022. As long as the recovery strengthens and becomes self-sustained, allowing the phase-out of the policy relief (with moratoria expiring and credit guarantees gradually removed), many firms will be exposed to debt repayments. In addition, some segments will face inevitable downsizing effects due to the structural changes in the consumption behaviour boosted by the crisis.
IMF evidence shows that the solvency stress is high in the hardest-hit sectors, especially across small and medium-sized enterprises with weaker earnings and impaired capacity to service debt, both in advanced and emerging economies. The March Bank for International Settlements (BIS) Quarterly Review assesses the potential corporate credit losses (defined as recognised impairments on bank and non-bank debt) at the sectoral level for the G7 countries, China and Australia until the end of 2022, assuming that the pandemic will have played out by then and its impact on credit losses will have materialised.
The authors find that the corporate credit loss rates could rise substantially in sectors most affected by the pandemic and that this sectoral dispersion is likely to be wider than during the GFC because of unevenness in sectoral economic conditions. At an aggregate level, however, corporate credit losses rates are likely to fall short of those sustained during the GFC, in large part because the sectors most affected by the COVID-19 account for a comparably small share of total credit. In a plausible central scenario, the corporate credit losses during 2020-22 could be three times pre-crisis levels on average across the G7, China and Australia, corresponding to a cumulative $1 trillion.
Risks of zombification
Our second point highlights the risks of increased ‘zombification’. The term ‘zombie firms’ defines those firms that are unable to cover debt servicing costs from current profits over an extended period, that would have failed even without the downturn triggered by the COVID-19 shock.
Abundant liquidity, together with policies that prevent creditors from enforcing claims on struggling firms, have allowed unviable firms in the corporate sector to survive. However, zombies weigh on economic performance because they are less productive and because their presence lowers investment in, and employment at, more productive firms. In addition, it can lead to structural slow growth, misallocation of credit, lower productivity and a less resilient financial system in the future, the IMF says. Smaller firms, in particular, seem to have benefited from these policies.
As suggested by the IMF, in order to prevent such zombie firms from continuing to take up resources, governments will have to roll back blanket loans and credit guarantees, relying more on dedicated out-of-court restructuring mechanisms and simpler procedures for reorganising small firms, restructuring loans, and filing for bankruptcy. In addition, lenders should be encouraged to actively identify and manage distressed borrowers, including while moratoriums and other support measures remain in place.
Economic recessions are always linked to waves of insolvency filings, both in advanced and emerging economies. Will zombie firms outlive the second half of 2021? Watch this space.
- Institute of International Finance, Global Debt Monitor, February 2021. ↑
- International Monetary Fund, World Economic Outlook, April 2021; World Bank, The Calm Before the Storm: Early Evidence on Business Insolvency Filings After the Onset of Covid-19, February 2021. ↑
- On average, corporate credit accounts for slightly more than half of total private non-financial credit in these countries (ranging from 31% of total credit in Australia to 73% in China) and typically incurs larger losses during recessions than household credit. ↑