The “zombie” companies might represent a drag on the economy if rates continue to rise and the economy enters a recession. (Photo: 123RF)
Defined as companies whose profits are insufficient to cover interest payments on debts, “zombie” companies might represent a drag on the economy if rates continue to rise and the economy goes into recession.
“Their effect on financial stability in a context of rising rates might become more pressing than ever,” thinks Sophie Osotimehin, professor of economics at the School of Management Sciences at the University of Quebec in Montreal.
With the difficulties caused by the pandemic, “there was a legitimate concern that, when mobility restrictions were lifted, a number of companies would not reopen their doors”, recalls Anil Passi, director, global corporate bonds at DBRS. Morningstar. Ultimately, he continues, most dodgy companies “did not foreclose or fail.”
Accumulate debts
However, with the dark economic clouds gathering and the threat of a recession looming, despite the current stock market rally, there is still concern that these companies may go bankrupt.
Easy credit conditions over the past decade, particularly over the past four years, “have allowed companies to rack up a lot of debt to get by,” notes Craig Basinger, head of market strategy at Purpose Investments. . “Look at the debt the airlines have accumulated. They are still able to cover it, but what will happen in the event of a recession?
It is still too early to tell whether the rise in interest rates and the slowing economy will lead to a substantial level of defaults and bankruptcies, said Mr Passi, considering that some difficulties are inevitable and that an anxiety excessive is unwelcome. “That’s the intention! he throws. That’s the point! If you don’t see business struggling because of rising rates, that means the central bank is irrelevant.”
If the difficulties exist, 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 have 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 that number in Australia. .
In the United Kingdom and the United States, the percentages hovered around 20%. The proportions were higher among listed SMEs, reaching 50%.
The greater presence on the stock market, particularly in the SME segment, explains the greater number of zombies among Anglo-Saxon countries, but also the importance of the raw materials sector, particularly in Canada and Australia, where zombies are numerous. On the other hand, the under-representation of SMEs in stock markets elsewhere, notably in Europe and Japan, prompted the BIS to consider its estimate of zombies in the world to be an understatement.
Proportion of capital less threatening
The economic weight of zombies is however much more modest than their absolute number, which puts the problem into perspective. The share of assets, capital and debt they house averages 6-7%, according to BIS calculations.
The Bank of Canada study arrived at a similar number of carpet zombies in the Canadian economy: around 25% in 2018. It also confirmed the BIS observation regarding commodities. “The growing share of zombie firms and their relatively high prevalence in Canada is driven primarily by firms operating in commodity industries,” the report writes. About two-thirds of zombie firms in Canada in 2018 were in industries exposed to commodity prices.”
However, while the BIS and OECD studies focused on the economic drag on productivity and growth posed by zombies, the CB perspective was unique in asking what might be the impact of zombies on the country’s financial stability following the effect of defaults on lenders.
From this perspective, Canadian zombies have a rather modest financial impact: “We find that zombie companies represent less than 2% of the debt, employment or market capitalization of all Canadian companies. Zombies are not a source of vulnerability for the financial system”, conclude the BC analysts.
Bigger Zombies Abroad
Case closed? Maybe not. There are potentially significant zombies around the world, especially in the United States, where companies like Carnival Corp. and 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 3,000 largest publicly traded US corporations and roughly US$900 billion in debt, were zombie nature.
In the event of a recession, might these debt masses collapse in a deluge of defaults and bankruptcies? “I expect to see an increase in bankruptcies, says Sophie Osotimehin, but for the moment, this is not really the case.”
Indeed, bankruptcies in the United States have just reached a historic low. Oscillating around 22,500 during the Covid, they fell to 14,347 in January 2022 and continued their downward trend with 12,748 in July. In Canada, bankruptcies are increasing, but not alarmingly: following falling to almost 100 per month during COVID-19, they have since risen to 240, thus returning to the average of the last decade.
The same goes for default rates, which are at historically low levels.
Of course, that might change in the event of a recession, as Deutsche Bank strategists Jim Read and Karthik Nagalingam forecast for the second half of 2023. At that time, defaults on junk bonds (the main zombie feeding ground) will rise from the current 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 hit. The ranks of those predicting one are dwindling, and Craig Basinger is one of them. “I think the zombie problem represents a narrow pocket. The inflation problem is regarding to disappear, I think; wage pressures are easing, hiring has moderated, commodity prices have fallen and we have reduced aggregate demand with rate hikes. I am optimistic regarding the second half of 2022, which I believe will be better than the first. »