The term “zombie company” has recently entered people’s lexicon as the phenomenon manifests itself in China. Yet this issue did not start with China, it is closely linked to the problems faced by Japan that started in the early 90’s, called Japan’s Lost Decade and sometimes the lost two decades, which arrested the development of their economy for at least a decade, even though the nation is known to be hard working and efficient. After all, Japan is the home of global super-companies such as Toyota and Sony so understanding how the economy stagnated could yield important lessons.
There are many closely related definitions for zombie companies but I will use one defined in the academic paper Zombie Lending and Depressed Restructuring in Japan published in the American Economic Review 2008. The definition that they give is:
A company with poor productivity and profitability that should have withdrawn from the market but continues to do business only thanks to support from creditors or the government.
A little history to give us some context. In the 1980’s Japan’s central bank fuelled an asset price bubble, predominantly in equities and real estate. In 1989 the government raised interest rates to prick the bubble which caused financial and asset markets to crash. Japan ran into a liquidity trap, unable to stimulate bank lending, whilst at the same time creating zombie banks via loans and cash infusions to troubled institutions that allowed these banks to avoid bankruptcy but they could never get the banks to actually increase lending commensurate with GDP.
Japan at that time had some unique circumstances that led to its lost decade, such as an ageing population. Nevertheless, these circumstances do not detract from the lessons one can learn with respect to zombie companies.
The next report on zombie companies that I found comes from a 2012 BBC article on the UK economy. This was initially surprising as the UK is normally more closely associated with complete free market capitalism, which would dictate allowing troubled companies to fail rather than putting them on eternal life support. The explanation comes from the nature of the support to these troubled companies. Instead of direct government support, the market supported these companies via low interest rates. This allowed the troubled companies to service their debts, and hence avoid bank triggered bankruptcy, without actually doing much else.
The article quotes that experts estimated the number of zombie companies at 146,000. An interesting argument is made in the article that these zombies are allowed to survive so that banks do not have to write off any outstanding loans. Remember, interests rates were low enough that these zombies could service the debt, so there were no defaults.
Low interest rates. Hmmm.
The most recent international case of zombie companies comes from China, triggered by its 2016 stock market crash. The problem here was excess industrial production capacity and a 2016 Wall Street Journal article details the specific example of Dongbei Special Steel Group. The basic issue here was that the Chinese economy was doing well, and companies found it cheap to raise equity financing, that the industrial sector simply over invested in capacity. When things inevitably returned to normal the revenue levels could not support the excess capacity of these companies. The Chinese government, afraid of the social consequences as well as potential effect on economy kept many state owned companies alive.
What can we learn here? Last year I did an analysis that showed gross fixed capital formation in the UAE, a measure of how much was invested in fixed, durable assets such as plant, machinery, equipment, buildings, roads and drains. It showed that starting in 2011 both growth in government spending, the major part of the market, and GDP growth dropped fast, whilst gross fixed capital formation continued to grow.
I haven’t bothered to update the graphs because here’s the point: the graph shows that as of 2014 we have overcapacity. Fixed capital is durable, how are companies going to sell plants and machinery quickly? And to whom?
The siren call of “just a little more funding, just a little more time” needs to be ignored, so that the inefficient companies can fail and allow the productive ones to thrive.