Zombification of Europe: time to rethink protection for all
The rise of a new generation of zombie firms across Europe is a stark example of consequential decision-making between bad options. When Europe staggered into the first covid-induced lockdown back in early Spring, the European Union (EU) and national governments across the Continent responded swiftly with a dizzying array of stimulus spending and monetary easing.
At the time, the market lauded the necessary co-ordinated measures to support eurozone companies which faced inevitably face cash flow problems and an inability to service debt which together posed insolvency risks. Unprecedented support by the European Central Bank (ECB), the EU and continental national governments propped up swathes of eurozone companies pushed to the brink, as forced economic hibernation and a cliff-edge collapse led to dramatic falls in revenues.
Macro and micro drivers
At the macro level, the ECB eased collateral requirements for access to Targeted Longer-Term Refinancing Operations (TLTRO III) in March. This enabled banks, including those with higher risks, with access to finance to lend to companies (and households) in the euro area. Given the interest rate for the ECB’s TLTRO scheme is priced off the ECB deposit facility, which is currently minus 0.5 per cent, this effectively amounted to ECB subsidising banks’ corporate lending. This subsidy which swiftly increased in April when the ECB introduced a -1% interest rate for euro banks that do not reduce net lending to companies (and households) for the 12 months to March 2021. This has flipped conventional capital allocation. Rather than corporates applying to banks for credit to finance investment, the ECB is now incentivising banks to lend credit with subsidies which increase banks’ net interest margin. The objective was to prevent bankruptcies, and protect jobs, not deliver expected returns.
Inevitably, banks plentifully availed themselves with this ultra-cheap three-year funding. In June, banks borrowed €1.3 trillion followed by a further €174.5 billion in late September, taking outstanding TLTRO loans to €1.7 trillion, according to the ECB. Concurrently, the ECB launched the Pandemic Emergency Longer-Term Refinancing Operations (PELTROs) scheme, 16-month term financing targeted at smaller banks ineligible for TLTRO. In the first round of PELTRO, €851 million was raised, at a shallower negative interest currently at -0.25%. National governments have also provided insulation to corporates, led by Germany which pledged €1 trillion in various loans, grants and subsidised job support schemes.
At the micro-level, the majority of eurozone governments loosened insolvency rules, including a moratorium on creditor rights to apply for bankruptcy filings for over-indebted firms, postponements to tax filing deadline and payments, and temporary suspension of director liabilities. There remain considerable differences between nations. For example, Germany has extended the moratorium on insolvency filings until the year-end for over-indebted businesses.
New generation of zombie firms
Collectively, these measures have supported banks and corporates in lower insolvencies, loan defaults and non-performing loan (NPL) ratios. As a result, corporate insolvencies fell by 6.2% in the first half of 2020, compared to the period in 2019, according to the German Federal Statistical Office. However, the number of potential corporate insolvency creditor claims spiked to €16.7 billion in the first half of 2020, up €6.5bn on in the same period in 2019, according to law firm Pinsent Masons. “The number of corporate insolvencies with a simultaneous increase in the total number of creditors’ claims [is] as an indicator for a highly increased risk of bankruptcies in large and medium-sized companies,” the law firm added. More broadly, more than half of Europe’s SMEs face bankruptcy in the next year if revenues do not pick up, according to a McKinsey & Company survey, with one in five companies in Italy and France anticipating filing for insolvency within six months. Indeed, many corporates only exist in the protective bubble of central bank generosity and insolvency loosening. These companies are kept afloat, somewhere between normalcy and death, and represent a new generation of living dead “zombie firms”.
Zombie firms are protected from the self-cleaning traditions of the market economy – namely, takeover or bankruptcy – despite persistent unprofitability. Necessary restructurings are postponed while banks intentionally do not price in default risk, relying on the endurance of low-interest rates which reduces the impact of debt service burdens.
In a study published in September, the Bank for International Settlements (BIS) showed that the proportion of listed zombie companies in most euro area countries was rising before the pandemic. This trend is almost certain to have intensified following more than €2 trillion in emergency lending, led by banks across Germany, Italy, Spain and France. In Germany, the number of zombie companies could double to one in six as a result of bailouts related to the pandemic, according to credit agency Creditreform. Listed zombie firms typically have negative cash flow, negative ICRs and are more prominent among SMEs. Compared to non-zombie firms, zombies are smaller, less productive, more indebted, with a more than two-fold increase in the probability of bankruptcy or takeover.
The main consequences of corporate zombification, in Europe and beyond, is reduced economic dynamism and performance, which creates “congestion effects” for productive firms and stifled vibrant new entrants. The BIS study, based on firm-level data on listed non-financial companies in 14 advanced economies, also showed that while the majority of firms managed to recover from zombification, those who did remained weak and acted as a drag on economic dynamics. “They have a high probability of relapsing into zombie status, and their dynamism and productivity are significantly lower than that of firms that have never been zombies in their life,” wrote Ryan Banerjee and Boris Hofmann, co-authors of the BIS study,Corporate zombies: Anatomy and life cycle. “In other words, the zombie disease seems to cause long-term damage also on those that recover from it. The weakness and risks in advanced economy corporate sectors may therefore not be fully captured by headline figures of the number of zombie firms.”
Banerjee and Hofmann concluded: “Our results underline the challenge the authorities face when taking measures to contain the impact of the coronavirus recession on firms. The delicate task is to seek to shore up companies that would be viable in less extreme circumstances while at the same time not excessively dampening corporate dynamism by protecting already weak and unproductive ones. A firm’s viability should be an important criterion for its eligibility for government and central bank support.”
To support firms that would struggle without coronavirus is a tacit reward for poor performance. It removes market differentiation between profitable and unprofitable business. The longer-term effects could be to erode the euro area’s productivity into, potentially, negative territory. It is the unintended consequence of fast-thinking responsiveness on the economic consequences of a global health crisis. Furthermore, some fear this zombification could infect the behaviour of healthy corporates who currently have cover to ignore any necessary restructuring. When these policies eventually unwind, whether next March or later, a wave of insolvencies could ensue, which will weigh on the labour market and the banking sector. The focus, perhaps, needs refining to curb expected future bankruptcies by supporting only firms with demonstrably sustainable businesses within a pandemic environment.