The “zombie” companies could weigh on the economy if interest rates continue to rise and the economy slides into recession. (Photo: 123RF)
Defined as companies whose earnings are insufficient to cover interest payments on debt, “zombie” companies could weigh on the economy if interest rates continue to rise and the economy enters a recession.
“Their implications for financial stability in the context of rising interest rates may become more urgent than ever,” says Sophie Osotimehin, an economics professor at the University of Quebec’s School of Management Sciences in Montreal.
Given the difficulties caused by the pandemic, “there was legitimate concern that a number of companies would not reopen their doors once mobility restrictions were lifted,” recalled Anil Passi, Director, Global Corporate Bonds at DBRS Morningstar. Ultimately, he continues, most shady companies “are not closed or failed.”
With the dark economic clouds gathering and the looming recession, despite the current stock market rally, concerns remain that these companies could go bankrupt.
Easy credit conditions over the last decade, particularly the last four, “have allowed companies to rack up a lot of debt to make ends meet,” notes Craig Basinger, head of market strategy at Purpose Investments. “Look at the debt the airlines have accumulated. You can still cover it, but what happens in the event of a recession?
It is too early to say whether rising interest rates and the slowing economy will lead to significant levels of defaults and bankruptcies, Mr Passi said, as some difficulties are inevitable and undue concern is undesirable. “That’s the intention! he throws. That is the point! If you don’t see the economy getting into trouble because of rising interest rates, that means the central bank is irrelevant.”
If the troubles persist, how vulnerable are zombie-weakened economies?
Lots of zombies in Canada
Three studies conducted by major institutions give us the scope of the problem. Between 2018 and 2020, the Bank for International Settlements (BIS), the OECD and the Bank of Canada all produced studies showing an alarming number of zombies in the global economy, particularly in Anglo-Saxon countries.
In the BIS study, Canada and Australia stood out as the two countries with the most zombies in 2017 – over 30% of listed companies in Canada and just below in Australia.
In the United Kingdom and the United States, the percentages hovered around 20%. Among listed SMEs, the proportion was higher, reaching 50%.
The greater presence on the stock market, especially in the SME segment, explains the greater number of zombies in Anglo-Saxon countries, but also the importance of the commodities sector, especially in Canada and Australia where zombies are numerous. On the other hand, the under-representation of SMEs in stock markets elsewhere, particularly in Europe and Japan, led the BIS to consider its estimate of the world’s zombies an understatement.
Share of capital less threatening
However, the economic weight of zombies is much more modest than their absolute numbers, which puts the problem into perspective. The proportion of assets, capital and debt they host averages 6-7%, according to BIS calculations.
The Bank of Canada study found a similar number of carpet zombies in the Canadian economy: around 25% in 2018. It also confirmed the BIS watch on commodities. “The growing proportion of zombie firms and their relatively high prevalence in Canada is being driven primarily by firms involved in extractive industries,” the report says. About two-thirds of zombie companies in Canada in 2018 were in industries exposed to commodity prices.”
However, while the BIS and OECD studies focused on zombies’ economic drag on productivity and growth, the CB perspective was unique in asking what impact zombies are having on the country’s financial stability after the impact of defaults on lenders could.
From this perspective, Canadian zombies have a rather modest financial impact: “We find that zombie companies account for less than 2% of the debt, employment or market cap of all Canadian companies. Zombies are not a vulnerability to the financial system,” conclude the BC analysts.
Bigger zombies abroad
Case closed? Maybe not. There are potentially significant zombies around the world, particularly in the United States where companies like Carnival Corp. and the American Airlines Group have indeed accumulated considerable debt, as Craig Basinger points out. A recent Bloomberg article calculated that more than 600 companies, representing one-fifth of the top 3,000 publicly traded US companies and around $900 billion in debt, are zombie in nature.
In the event of a recession, could this mass of debt collapse in a spate of defaults and bankruptcies? “I expect bankruptcies to increase,” says Sophie Osotimehin, but that’s not really the case at the moment.”
In fact, bankruptcies in the United States have just reached an all-time low. They hovered around 22,500 during the Covid, falling to 14,347 in January 2022 and continuing their downward trend to 12,748 in July. In Canada, bankruptcies are rising, but not alarmingly: After falling to almost 100 a month during COVID-19, they have since risen to 240, returning to the average for the past decade.
The same applies to default rates, which are at historically low levels.
Of course, that could change in the event of a recession, as Deutsche Bank strategists Jim Read and Karthik Nagalingam forecast for the second half of 2023. Then defaults on junk bonds (the main feeding ground for zombies) versus the current will surge to an all-time high of 1% to 5% by the end of 2023 and then to 10.3% in 2024, which is very close to previous all-time highs of 12%.
But then one wonders if a recession will come. The ranks of predictors are dwindling, and Craig Basinger is one of them. “I think the zombie problem is a tight pocket. The inflation problem will go away in my opinion; wage pressures are easing, hiring has eased, commodity prices have fallen and we have reduced aggregate demand by raising interest rates. I am optimistic for the second half of 2022, which I believe will be better than the first. »