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Zombie Companies: How Central Bankers Are Killing Growth

After the bubble burst in January of 1990, the Japanese lowered interest rates. Many companies that should have gone bust continued to operate. These companies were able to stay afloat because they had access to bank loans at cheaper interest rates than the risks warranted; in effect they received subsidized credit. At one level this program worked quite well. The companies that received this credit ended up losing fewer jobs than other companies who were left to market forces. So from a policy standpoint, the low interest rates appeared to be a great success by reducing the pain. But there was one problem.

The lowered interest rates created the dreaded zombie company. These are companies with just enough cash flow to service their debts at very low interest rates, but insufficient profit to invest and grow. They can't innovate. They can't expand. They can't create more jobs. They just exist. They are now they are not just in Japan. They are everywhere.

Japanese zombie companies are still there. About two thirds of Japanese firms do not earn a taxable profit. Over the past decade a quarter of the companies listed on the Tokyo Stock Exchange failed to achieve operating margins above 2%. Like the flu presently spreading throughout the US, zombie companies can infect entire industries. They keep productivity low, put off new entrants, keep workers in unproductive jobs and discourage investment by driving down prices. They are also hard to get rid of.

As long as interests rates stay near zero banks can avoid restructuring or forcing the zombie companies into liquidation. As long as they have sufficient cash flow to service the loan, the loan does not have to be written off. All banks have to do is to extend the loan to avoid heavy losses. At long last even the governor of the Bank of Japan, Masaaki Shirakawa, has acknowledged that a policy of near zero interest rates hurts corporate growth.

Japan has often been the poster child for zombie companies, but now that all of the central banks have gotten into the loose money business, they have spread to Europe. During 2010 30% of English companies were losing money. Although this is a larger proportion than in the recession of 1990, the rate of insolvency was less. They manage to stay afloat because one in ten companies can manage interest payments but cannot reduce the principal. Companies in this category have increased by 10% in the last five months.

European countries have similar stories to England especially in the peripheral countries. During 1990s recession Europe's economy contracted by only 1% compared with 4% in the present recession. Yet the default rate for subinvestment grade debt was 67%. During the worst of the recession the default rate did not exceed 9%. It now stands at only 2.3%. One would expect that in financially distressed countries like Greece, Spain and Italy would have the highest levels of insolvencies, but in 2011 they had the lowest even though only two thirds of the companies were making a profit.

Emerging markets are supposed to be the hot beds of growth rather than the preserve of marginal companies, but these economies are infected with zombie companies. Most companies in India are fairly healthy despite the down turn but large capital intensive industries like telecoms, construction and infrastructure are loaded down with debt. The largest 80 listed firms increased their debt from $29 billion in 2007 to $163 billion today. The over reliance on debt rather than equity is to some extent part of local conditions. Promoter groups made up of clans or individuals who control these companies dislike diluting their interests by issuing equity and instead rely on debt. Some of the money is readily available from public sector banks that hold up to 93% of the restructured loans. This especially true of the smaller pubic banks where 80% of these restructured loans reside.

Not to be outdone China has its own huge state owned banks that are propping up zombie state owned companies with subsidized capital. Of the largest central enterprises more than two thirds lost money in the first half of 2012, yet there is never any discussion of insolvency. Often the zombie company is owned by a local government who can keep it alive with cheap loans from local branches of large state owned banks. The problem is that these local governments are heavily indebted. They borrowed 10.7 trillion yuan ($1.7 trillion) and after a brief slow down have started again increasing their borrowing 148% since 2011.

Central bankers have insisted that their policies of ultra lose money have been successful in preventing a more serious downturn. No doubt this is true, but treating symptoms is not a cure. In the process they have also managed to kill growth.