Can Zombie Firms Survive Rising Interest Rates?
Economists have been warning for years about the rising number of “zombie firms” companies that don’t generate enough cash to pay the interest on their debts. Companies that can’t pay their debts are supposed to turn things around, restructure, or go out of business. But zombies just keep staggering along, tenuously alive, and some researchers worry that they act as a drag on the entire economy by using up resources that could be better spent elsewhere. With economic conditions changing rapidly, however, these firms might start dying off. Zombies feast on cheap credit, and rising interest rates mean that’s suddenly in short supply. “Some say [zombies’] time is running short,” Bloomberg News reported in May. “The end result could be a prolonged stretch of bankruptcies unlike any in recent memory.”
The risk from that scenario is not a massive one-time shock like the financial crisis of 2008. It’s a slowrolling wave of bankruptcies and restructurings dragging on for years as debts come due. That could mean major layoffs and considerable losses for investors and it could help usher in a recession or make it harder to recover from one. But, because it would push zombies to sell off assets, it could also create new opportunities for businesses and investors.
A Short History of Zombie Firms
Research on zombie firms began with an investigation into Japan’s “lost decade” in the 1990s. As Japan’s economy soured, a number of Japanese firms weren’t able to pay even the interest on their debts. Normally these firms would have gone under, but many banks chose to let firms pause their payments to avoid admitting to their shareholders that the loan likely would never be fully repaid. As a result, the banking industry kept these struggling firms limping along for years. The zombie phenomenon wasn’t confined to Japan, however. After the financial crisis of 2008, reports of these companies started popping up everywhere. In 2017, economists at the Organisation for Economic Co-operation and Development (OECD) published a paper suggesting that zombie firms appeared to be on the rise across the combined economies of Belgium, Finland, France, Italy, Korea, Slovenia, Spain, Sweden, and the UK. Moreover, that increase seemed linked to sluggish productivity growth. The continued existence of these firms was bad for the economy, they argued. It might prevent some pain in the short-term, but it prevented new companies from getting started and more productive firms from expanding. The zombies were claiming market share that someone else could make better use of. What was behind their proliferation? In 2018, economists at the Bank for International Settlements, a cooperative of central banks, provided an answer. They linked low interest rates to the rising number of zombie firms. The countries where rates dropped farthest were the ones where the share of zombie firms increased the most. And they found that the industries with the highest percentage of zombies were natural resources like coal and metals, followed by pharmaceuticals.
To be sure, all the research on zombies is hotly contested, starting with how to define the term. Most definitions start with a firm not generating enough in earnings before interest and taxes (EBIT) to cover its interest payments for multiple years in a row. But that definition captures lots of younger, fast-growing, perfectly healthy firms. So, researchers often add a measure of the firm’s age or market cap to prevent growth companies from getting classified as zombies. Moreover, not every study has found a pronounced increase in zombie firms. A Goldman Sachs research note from 2020 concluded that there’d been no increase in zombie firms in U.S. public markets, going so far as to call the zombie trend “more fiction than fact,” at least in bond markets. Goldman’s skeptical take provides a hint about how zombies are born: the type of borrowing makes a difference. In Japan’s case, zombies were funded directly by banks. Much of Europe operates that way, too. In the U.S., by contrast, companies mostly borrow via the bond market, which is what Goldman analyzed. Bond markets seem far less likely than banks to prop up zombie firms.
Can Zombies Survive Higher Interest Rates?
The current economy is bad news for zombie firms. Higher interest rates put pressure on them, for a few reasons:
1. Higher interest rates lower demand in the economy, meaning less revenue for many companies, which in turn means even less cash to pay down debt.
2. They make raising new funding more challenging, as firms that couldn’t cover their interest payments at lower rates will fall even farther behind if they borrow at higher ones.
3. As interest rates rise, investors and banks have less interest in lending to zombies, because higher rates mean they have better, safer options. As such, rising rates will likely push more zombie firms into bankruptcy, says Noel Hebert, an analyst at Bloomberg Intelligence. And it will push more healthy firms toward zombie status: Companies that could cover their interest payments may no longer be able to if they have to borrow at higher rates. Bankruptcy isn’t the only option for zombie firms, though. They can sell off assets, too, and that can be an opportunity for healthier firms. Private equity firms aren’t the only ones keeping an eye out for struggling companies looking to sell off businesses; companies with lots of cash or the ability to raise money will also be able to buy low if interest rates continue to rise quickly in the next year. There’s also the possibility that interest rates won’t go that high, and that central banks succeed in engineering a “soft landing,” taming inflation without a recession. Over the last few weeks, prices in the junk bond market rose based on positive news regarding U.S. inflation. The amount of pressure on zombies will depend on how bad things get.
The Productivity Puzzle
Research into zombie firms tends to imply that higher interest rates will mean fewer zombies, and that fewer zombies will mean higher productivity growth. If struggling, unproductive firms are forced out of the market, the theory goes, the long-term economic picture will brighten.
Maybe. But anyone looking for ways to improve an economy’s productivity should focus elsewhere. Interest rates are too blunt a tool to drive productivity growth, and if they induce a recession, that’s as likely to scar the economy as to cleanse it. The ultimate drivers of an economy’s potential are more basic: struggling firms should try to turn themselves around, healthy firms should innovate and try to out-compete their rivals, and investors should do the due diligence necessary to tell the difference. An economy’s share of zombie firms depends just as much on all those daily business decisions as on the choices of central banks.