There is a prevalent view that part of the reason for the UK’s slow recovery and poor productivity is the existence of large numbers of companies that should have died in the recession. “Zombie firms in danger of strangling the economy”, screams one newspaper headline. And another warns of the “Zombie businesses spreading like a virus”.
It’s not always clear what people mean by a “zombie company”. The usual definition of “zombie” is one that generates enough cash flow to service its debt but not enough to repay principal, or alternatively one that generates enough cash flow to survive but not enough to grow. But lots of businesses don’t grow. Indeed, the majority of microbusinesses – sole traders and firms with fewer than 9 employees – not only don’t grow but have no desire to do so. Are they zombies? No. They are active economic agents contributing to the economy. We really can’t use the absence of growth as an indication that a company is not viable. Many of these companies happily bump along the bottom for decades.
Indebtedness does seem to be characteristic of zombies. Tom Papworth, in this paper for the Adam Smith Institute, defines five key indicators that a firm is a zombie:
1. The company is heavily indebted
2. The company is able to generate enough revenue to pay the interest on its loan but is not able to pay down the principle
3. The ability to meet loan interest payments is dependent upon continuing low interest [rates]*
4. The above prevents the company from restructuring and so becoming more profitable
5. The above vitiates the need for the company to go into receivership, thus preventing the redeployment of capital and labour to more productive sectors.
And he goes on to describe four types of zombie:
· Firms that are unprofitable because either the firm or the sector is in long-term decline: low interest rates simply delay their exit from the market
· The firm is at an early stage of development and has not yet reached the stage where it turns a profit;
· The firm is suffering from the cyclical downturn and will return to robust health once the economy recovers;
· The firm is struggling due to management practices or a corporate structure that is not (or is no longer) fit for purpose.
Of these, only the first can really be said to be a zombie in the sense that it is being artificially kept alive by low interest rates. The rest are all potentially viable firms which would recover with the right treatment – which certainly would not include raising interest rates prematurely. Killing off these firms would not promote recovery. Indeed, as Papworth notes, killing off developing firms (type 2) may even delay it:
“To terminate these firms in a misguided belief that capital and labour needs to be reallocated would be to kill the next generation of firms and undermine the process of creative destruction.”
So the argument that the UK’s recovery is being held back by a
plague of zombies rests on the presupposition that the UK has a lot of the
first type of zombie and very few of the rest. Unless there is considerable
evidence of this, raising interest rates or tightening credit standards to
clear them out is a high-risk strategy. So is there conclusive evidence that
the UK has a real zombie problem?
Papworth uses two key pieces of data to indicate the presence or otherwise of zombies that should be terminated. The first is the number of companies reporting difficulty meeting debt obligations, which has risen in the past year:
The problem with this is that an increase in corporate distress
can actually be a good sign. Zombie companies don’t necessarily appear distressed – they
are servicing their debts, although not paying principal. But the chart above
shows that interest-only payments, which would be typical of zombies, are
declining. What is increasing is corporate debt distress and restructuring.
Restructuring can get companies out of trouble, or it can be part of a long
downwards spiral that eventually ends with the company being wound up. Either
result is good for the economy.
The second is the rate of corporate insolvency. This is by no
means straightforward. Papworth notes that the rate of corporate insolvency is
low by comparison with the 1990 recession. But Gareth Rumsey of Experian, in a recent
presentation on zombie companies at an event organised by ACCA SME, observed that there were a large
number of “hidden “ insolvencies in the recent recession, where firms wind
themselves up rather than going into insolvency:
Adding in the “hidden” insolvencies gives a failure rate that is actually higher than in the 1990 recession. Papworth’s own chart supports the idea that voluntary liquidations are forcing down the compulsory liquidation rate:
But he then bizarrely suggests that this indicates forbearance by
creditors. How he reaches this conclusion is beyond me – and it is utterly
inconsistent with the description given by Ben Cairns of Ernst & Young of
their management of corporate insolvency. Voluntary liquidation is often agreed
with creditors because it gives a better outcome for all concerned than
bankruptcy proceedings. But a company that has wound itself up, sold its assets
and settled its debts is just as much a dead company as one that has been
expensively forced through bankruptcy proceedings. “Hidden insolvency” is in no
respect forbearance creating a zombie. The difference is in the management of
insolvency, not in the rate of corporate failure.
And I was disappointed that Papworth did nothing at all with this chart, which for me spoke volumes about the changing nature of business in the UK:
So there is a long-term downward trend in the rate of corporate insolvency, and a corresponding UPWARD trend in individual insolvency. How many small business owners pledge their houses to obtain business finance – and go personally bankrupt when their businesses get into difficulty paying their debts? Come to that, how many microbusinesses failed in the recession? Experian say it’s rather a lot – in fact more microbusinesses appear to have gone out of business at the height of the recession than any other category:
So the overall picture is one of tiny businesses going out of business in huge numbers, but not showing up in the official insolvency statistics because they wind themselves up and their owners take the hit in mortgage default and personal bankruptcy. This is consistent with the rising proportion of businesses that have fewer than 9 employees:
It’s worth remembering, too, that the majority of small businesses in the UK are sole traders – and they don’t go bankrupt as businesses, but as individuals.
Papworth expresses some puzzlement that the rate of corporate insolvency appears low. His puzzlement is understandable. It is not low. He is looking at the wrong data. And because of this, the rest of the paper is seriously flawed. I am not going to argue with his use of Austrian business cycle theory, or Schumpeter’s theory of “creative destruction”. But since he is using the wrong data, he has not put together a convincing case for the existence of the zombies he says need to be cleared out.
Experian went on to demonstrate that in their view the UK’s corporate sector is in better shape now than it was before the recession. According to their data, the companies that failed in the recession were those that were financially weakest:
And their indicators suggest that the general financial
strength of corporations has improved:
Gareth Rumsey commented that Experian were very concerned about the prevalence of the “zombie” myth, which they considered did not accord with their own research, because of the risk that it would result in inappropriate policy action. Indeed the claims by Papworth and others that zombie companies are holding back growth have resulted in calls for interest rates to be raised to “clear out the zombies”.
Also, because it is widely believed that zombies are kept alive not just by low interest rates, but by damaged banks unable to take losses, there are calls for banks to “end forbearance” even if it means they fail themselves. This is madness. Every bank and building society in the UK has corporate debt on its books, and almost every bank and building society in the UK has a damaged balance sheet which could not cope with large amounts of insolvencies. So banks cannot “end forbearance”. Nor do we wish them to do so. Widespread losses across the entire UK banking sector would catapult the UK back into deep recession. I am no fan of damaged banks – indeed I have called for them to be bypassed so that the UK economy can get the credit it desperately needs. But that doesn’t mean that it would be sensible to bankrupt them all.
So it seems there is little evidence for the existence of zombie companies. But there is considerable evidence for the existence of zombie banks. Indeed the very term “zombie” was originally used about banks. During the American Savings & Loan Crisis of the 1980s & 90s, Edward Kane described a “zombie” thus:
A zombie institution is a deeply insolvent firm that continues to operate only because its ability to cover its various obligations is shored up by implicit or explicit government credit support.
But he was talking about the thrifts and small banks that were bailed out by the US government and the Federal Reserve at that time. And he would no doubt say the same about the banks that have been bailed out and are still being supported by governments and central banks around the world.
Papworth should lay his axe to the right tree.
* Papworth says "interest payments". I have changed this to "interest rates" to make it clearer.
Zombie image from Wikimedia Commons.
Experian charts reprinted with their permission.