Few people were surprised when the US retailer Sears Holdings filed for bankruptcy in October 2018. For many years, the Chicago-based company had been stumbling from one crisis to the next, amassing outstanding debt of around $5.6bn. When the firm was unable to pay a $134m tranche, its leadership decided to accept the inevitable and sought Chapter 11 protection, putting the jobs of 89,000 employees at risk.
Founded in 1893, Sears had been a pioneer of innovative retail practices, such as the issuing of merchandise catalogues and setting up department stores targeted at male customers. At its apogee in the 1980s, the company was the US’ biggest retailer – a position it ceded to Walmart in 1990. Hit by shifting consumer habits and the rise of online retailers, the company’s sales began declining, and in 2011, it ceased to be profitable.
Its chairman, the hedge fund manager Eddie Lampert, tried to prop up the company through share buybacks – an unorthodox tactic in the retail sector. Mark Cohen, Director of Retail Studies at Columbia Business School and former chair of Sears Canada, told World Finance: “Sears under Lampert’s control was never run as a legitimate enterprise. His modus operandi was and always has been to load the company up with as much debt as necessary to keep it solvent while he systematically stripped its assets for cash, largely for his own benefit.” This view was shared by Sears, which accused Lampert of looting the retailer’s prize assets in 2019. Lampert’s hedge fund, ESL Investments, has vigorously disputed these claims, calling them “fanciful”.
As in Europe and the US, the Chinese banking system has contributed to zombification
According to Ray Wimer, a professor of retail practice at Syracuse University, the firm’s soaring debt was an unbearable burden that contributed to its demise: “They were known for their appliances and hardware, things like automotive tools, refrigerators and batteries, and they started selling these brands off to raise capital to pay down the debt. That was the time when everyone in retail was heavily investing in launching their own brands, and [Sears was] getting out of it.”
Run into the ground
Sears is an extreme but characteristic example of what economists aptly call a ‘zombie’ company – an organisation that is unable to finance its debt with profits for an extended period. In an influential 2018 paper published by the Bank for International Settlements, economists Ryan Banerjee and Boris Hofmann examined data from 14 advanced economies. They found that the number of companies with zombie-like traits had been growing since the late 1980s, reaching on average 12 percent of all listed non-financial firms by 2016.
The term was coined in 2006 in a much-quoted paper examining the role the Japanese banking system played in the country’s ‘lost decade’ in the 1990s. Although Japanese policymakers have managed to tackle the problem since then, the term has come back in vogue due to the increasing number of highly indebted firms in Europe and North America – a trend that spiked after the global financial crisis in 2008. Definitions for what constitutes a zombie firm vary, but a widely accepted measure is an interest coverage ratio that has been below one for three consecutive years, notably for companies that have been operating for more than a decade. Many of them receive directly or indirectly subsidised credit, as in the case of many companies in East Asia and Southern Europe.
Some sectors are more vulnerable to zombification than others. Retail powerhouses such as Sears and Toys R Us – another US retailer that filed for bankruptcy in 2017 – struggle to adjust to the challenges facing the sector. The only reason they stay afloat is a combination of favourable financial conditions and sheer size, as suppliers are reluctant to pull the plug on them. As Cohen explained to World Finance: “Decades of excessive expansion of square footage have finally caught the industry in a deepening productivity crisis. There are too many undifferentiated stores (and malls), and creeping expense inflation concurrent with deflationary pressure on retail prices [has] created a deadly margin squeeze.”
Changes in consumer behaviour have also played a role, as e-commerce powerhouses such as Amazon and Alibaba have gradually killed brick-and-mortar stores. Cohen believes adjusting to the needs of the digital era comes at a cost: “E-commerce development comes with a whole host of challenging expense and margin issues because e-commerce sales are typically [made] at very… low prices, customer acquisition and fulfilment is increasingly expensive, and e-commerce returns are extraordinarily higher than returns from brick-and-mortar stores, further eroding margins.”
Many retailers resort to arcane financial tactics to survive until better days come. Sears is a case in point. “Lampert had his own hedge fund, and because Sears had his backing, they were allowed to take more debt,” a source familiar with the company’s demise told World Finance. “But are you going to trust the financial wizard who has that kind of reputation to save you?”
In many cases, what keeps zombie economies alive is political pressure. Arthur Guarino, an associate professor of professional practice at Rutgers Business School, told World Finance: “If left to free-market economic principles and ideas, many of these companies – perhaps 50 percent or more – would fail, resulting in high amounts of unemployed people.” For retailers, though, bailouts are out of the question. As Cohen explained: “Unless you are a farmer receiving billions of dollars [from US President Donald Trump’s] tariff-driven disruption payments, workers losing their jobs are out of luck.”
Low interest, high debt
Most experts agree that the monetary policies seen over the past decade have exacerbated the problem. Historically low interest rates coupled with quantitative easing (QE) may have helped developed economies avoid collapse during the 2008 financial crisis, but they have also created a credit bubble that is difficult to sustain.
Emre Tiftik, Director of Sustainability Research at the Institute of International Finance (IIF), a global association of financial institutions, told World Finance: “The low-interest-rate environment has been one of the main drivers of [the] rise [in zombie firms]. Easy access to cheap credit with longer maturities continues to support many firms that otherwise would hardly survive.”
Loose monetary policy also pushes investors to seek riskier opportunities, such as bonds issued by heavily indebted firms. “Low interest rates provided a foundation for more aggressive financial policies and ‘riskier’ behaviour on the part of issuers, as well as higher tolerance for these as a way to quench the thirst for yield on the part of investors,” Sudeep Kesh, Head of Credit Markets Research at S&P Global Ratings, told World Finance.
As in Europe and the US, the Chinese banking system has contributed to zombification
The result is a vicious cycle of soaring debt – low interest rates are necessary to sustain growth, leading to increasing numbers of zombie companies in Europe and the US. According to Cohen, many retailers have benefitted from this trend: “There is no question that low interest rates and QE [have] created an environment in which enormous sums of money have been easily and inexpensively deployed by private equity firms to acquire and load up retailers’ balance sheets with debt.”
To make things worse, the proliferation of zombie companies has caused what economists call ‘congestion effects’. By draining resources such as capital and workers, zombie firms make it more difficult for profitable companies to grow. Most economists agree that they distort competition, reduce productivity and hamper growth, although some question whether more productive companies would emerge if zombie firms in less dynamic economies, such as those of Southern Europe, were forced to shut down.
The rise of zombie firms partly explains the increasing rates of corporate debt globally (see Fig 1). According to the US Federal Reserve, US corporate debt reached $6.5trn last year, while non-financial corporate debt, loans and debt securities hit 74.45 percent of GDP in 2018, surpassing the figures recorded in the wake of the global financial crisis (see Fig 2). “The riskiest firms with low earnings have accounted for the bulk of debt build-up in recent years,” Tiftik said.
“While large US firms’ balance sheets look much stronger than they were before the 2008-9 crisis, the SME segment has become more fragile and remains largely exposed to sudden shifts in risk sentiment.” According to the latest IIF data, the picture is similar in the eurozone, where non-financial corporate debt stood at 107.9 percent of GDP in Q3 2019, close to the peak of 112 percent witnessed in 2015.
Many point to the banking sector as the main culprit, as banks with fragile balance sheets are reluctant to write off debt that would affect their liquidity and solvency ratios and bring them closer to regulatory scrutiny. “The problem is that unless banks are highly regulated by a central bank in how loans may be granted, they will continue to make high-risk loans,” Guarino explained to World Finance, pointing to the subprime mortgage crisis – during which high-risk borrowers were allowed to buy homes without sufficient scrutiny – as an example.
Currently, most investors expect central banks to intervene in cases of tighter financial conditions. However, Guarino doubts whether they will have enough leeway to avert a crisis: “When an economic recession or slowdown occurs, central banks have little recourse, such as further lowering interest rates. Rates will be so low that going down further either means hitting zero rates or perhaps going into negative territory.”
In China, zombie companies are partly responsible for the country’s soaring debt, which rose above 300 percent of GDP for the first time in 2019 (see Fig 3). According to Fitch Ratings, a record number of Chinese private companies defaulted last year – and the trend is expected to persist in 2020.
When the Chinese economy kicked off its export-driven boom in the early 1990s, many state-owned enterprises (SOEs) were closed or privatised. By the end of the 2000s, when the country had started to become competitive in world markets by building cost-efficient economies of scale, such pressure had already slackened. The tipping point came in the wake of the global financial crisis, when China launched a $600bn stimulus programme to avert the lack of demand that afflicted the US and Europe. The country’s banks were forced to pump the economic system with corporate loans, many of which were made to loss-making SOEs.
The result was a credit bubble, with corporate debt reaching 160 percent of GDP in 2018 – double its size from 2008. In 2009, Deutsche Welle, a German international broadcaster, estimated that more than 10,000 zombie companies were operating in China, around 20 percent of which received funding from the central government.
According to Dinny McMahon, a journalist and author of the book China’s Great Wall of Debt: Shadow Banks, Ghost Cities, Massive Loans and the End of the Chinese Miracle, a key difference between western and Chinese zombie companies is the way the latter stay afloat: “Chinese zombies are kept alive by local governments, [which] provide subsidies and lean on banks to provide sufficient credit to ensure they remain viable. Local governments in China are driven to keep zombies alive because they are still capable of generating tax revenue, even if they’re operating at a loss.”
The Chinese Government is dealing with the problem through a series of measures, including forced mergers. According to McMahon, its supply-side structural reform programme has helped ease the problem by reducing industrial overcapacity. He told World Finance: “The government doesn’t want to see large SOEs collapse and it will do whatever is necessary to ensure they continue to function. However, the central government wants to do it as cheaply as possible.”
Last October, Chinese authorities announced they had cleared up more than 95 percent of zombie companies, intending to phase out the rest by the end of 2020. A reform plan launched in 2019 forbade central government agencies and local governments from providing financial support to zombie firms. However, some cracks have already started to appear in the system: in 2016, Guangxi Non-ferrous Metals Group, a state-owned metal producer, became the country’s first major interbank bond issuer to go through involuntary liquidation, with debts totalling CNY 14.5bn ($2.09bn).
Raising the dead
As in Europe and the US, the Chinese banking system has contributed to zombification. “China’s banks have been essential in allowing China’s zombie firms to continue operating,” McMahon told World Finance. “If banks weren’t willing to exercise forbearance on delinquent loans, or weren’t willing to capitalise unpaid interest when rolling over a loan, zombies would be forced into bankruptcy.”
Over the past few years, Chinese banks have increased disposals of non-performing loans, helping zombie firms to gradually reduce their debt burden. Although most banks have been able to recapitalise, a crisis might be looming, given the lack of transparency. “The official non-performing-loan ratio is still only about 1.86 percent,” McMahon said. “That grossly understates the extent of the problem. However, it means that the banks can clean up their bad loans gradually, without having to recapitalise in a hurry. The magic of the clean-up process that China is going through is this: it’s happening in slow motion.”
Several Chinese banks have been bailed out over the past four years. The People’s Bank of China took Baoshang Bank into receivership last year, while Hengfeng Bank was effectively nationalised through a subsidiary of the country’s sovereign wealth fund. Although most of these institutions are small, fears over the resilience of China’s banking system have not abated. According to Guarino, the government goes to great lengths to hide the problem for good reason: “China is said to have numerous zombie banks, but disclosure of such information would probably cause a panic that could ultimately result in the global bond and stock markets [witnessing] a serious decline in a relatively short time.”
In 2016, Beijing launched a deleveraging campaign to crack down on controversial practices that could put the country’s financial system in danger. For McMahon, though, this was “something of a misnomer”, given the programme’s inherent contradictions. He told World Finance: “China can’t afford to deleverage. The economic model means that a certain level of growth is only possible if the level of debt expands faster than the pace of economic expansion.”
Broader macroeconomic trends may also play a role. Last year, China recorded a growth rate of 6.1 percent, its lowest for nearly 30 years. As the country’s economy slows further – due, in part, to ongoing economic reforms and the COVID-19 crisis – debt is expected to increase. However, McMahon believes China’s banks have been raising new capital in preparation for writing off more bad loans: “We have no way of knowing whether the pace [at] which banks are disposing of their bad loans is greater than the pace at which new bad loans are being created. If the pace of new bad loan creation is faster, then the banks are only delaying the reckoning – 2020 will offer something of a litmus test.”
A meltdown of zombie firms will have a spillover effect on healthier parts of the economy
It is uncertain how the zombification of the world’s biggest economies will evolve. Some experts believe growing inflation will gradually kill most of these companies, but a more abrupt ending is also likely. Slowing growth in China, the global effects of COVID-19 or any geopolitical crisis may force central banks in the US and Europe to raise interest rates. The impact may be dramatic for heavily indebted companies. As Guarino explained to World Finance: “Many American corporations took full advantage of low interest rates in the last economic crisis… and loaded up on so much debt that a recession, perhaps even a mild one, could ruin their income statements and especially their cash flow statements.”
A meltdown of zombie firms will have a spillover effect on healthier parts of the economy, as low-quality borrowers that are more sensitive to economic shocks may find it impossible to refinance debt or raise new capital. Some think that we are still far away from the brink of a crisis similar to the one that gripped the global economy in 2008. As Kesh told World Finance: “Maturities are largely manageable in the near term, as monetary easing by central banks will continue to support favourable funding conditions. Further, 77 percent of the debt due through 2024 is investment-grade.”
However, for those who are less optimistic, such as Guarino, the worst may still be ahead of us: “The next recession could possibly reach the scale of the financial crisis of 2008-9, since the American economy will see the corporate debt bubble pop in a manner we have not seen for a while.”