“Zombie” companies: – Why corporate bankruptcies have to increase to spur recovery

Corporate bankruptcy plays a very important role within a competitive, free-market economy. Enterprises that fail were either providing a good or service that was not in sufficient demand from the rest of the economy or were providing a good or service that was not competitive with other providers in the marketplace.  Bankruptcy provides a means for the resources that were being used by the unsuccessful company to be taken from inefficient use to a more efficient use.  If this is continually occurring throughout the economy, then the use or resources will be efficient and the level of economic activity will be greater.

The US economy has generally been very good at this.  As the fortunes of industries wax and wane, both capital and workers can be seen moving from the struggling parts of the economy to the newly growing and profitable parts.  Private sector capital will always be highly mobile, but with relatively poor welfare benefits and the advantages of a common language and laws, the US workforce is also very mobile and ready to change geography and sector of work.

The above is fine in theory.   However, for politicians, elected by voters who want secure jobs, the concept of long term resource efficiency will often play second fiddle to protecting companies from going bankrupt and making their workforce unemployed.  If too many bankruptcies (that should have occurred) are avoided, then there will be adverse economic consequences.

Japan’s long period of very slow growth since 1990 can be at least partially attributed to the reluctance of their banks to foreclose on companies and force them into bankruptcy.  The alternative was to reduce the interest rates due on the loans to very low levels, even though there was little prospect of ever repaying the principal amount – in Japan they are known as “zombie” companies.  This reluctance was for two reasons. Firstly, the banks themselves were critically short of capital, and forcing companies into bankruptcy would mean that they would have to acknowledge losses, which would reduce their capital base and weaken the perception of their capital strength in the market.  Secondly the culture of Japanese society, which like many Asian cultures, places a large emphasis of maintaining “face” and avoiding “shame”.   Going bankrupt and formally not making good on your responsibilities to creditors is seen as very shameful, and many will go to great lengths to avoid it.  In the US by contrast, having a company go bankrupt is seen as part of the learning process to becoming a successful entrepreneur.

Recent data on European bankruptcies by Creditreform Research , is very illuminating.  When ranking European countries by the number of corporate insolvencies per 10,000 businesses in 2011, the four countries with the lowest rates of insolvency are Greece (5), Spain(18), Italy (26) and Portugal (57).  These are the Eurozone peripheral countries with the poorest economic performance.  The countries with the highest rates of insolvency are Austria (152), Denmark (182) and Luxembourg (316), which have all been relatively successful European economies.   The differences in this data between countries strongly supports the idea that an insolvency process that allows bankruptcies to occur easily, works to the benefit if the economy as a whole.

After the 2008 Crash, one of the surprises in the UK economic data in the face of weak economic performance, has been the rate of corporate insolvencies.  In the 1990s, business liquidations averaged about 160 per 10,000 companies, but during and since this crisis the number has not even reached 100.  There is a general sense that, as in Japan in the 1990s, banks are not foreclosing on companies.  This is (i) to avoid even more bad publicity than they have been receiving already, (ii) to avoid selling off whatever assets there are at knock-down prices and so realise larger losses than might be warranted, and (iii) to avoid write-offs from their capital bases at a time when their regulatory capital requirements are rising sharply.  Thus, as in Japan, they are content to roll over existing debt at low interest rates, even though they know that their collateral is worth far less than the loans against it.

The UK therefore probably now has a fair share of “zombie” companies. In the longer term, this will tend to inhibit recovery and growth in the UK economy, but in the shorter term it may well explain why the UK unemployment data has been consistently better than expected.  The other conclusion is that considerable, unrecognised bad debts still exist within the UK and European banking systems.  This underpins our concern that there will not be a return to stronger growth in the UK and Europe for several years ahead, which will limit returns from financial markets.