Zombie firm

A zombie firm is a company that is currently able to stay in business but is loaded with bad debts and needs bailouts to survive.

For example, a company which took on large debts but then a rise in interest rates makes these form debt repayments unaffordable and it would go under – without support from banks or governments.

In this sense, a zombie firm is a going concern but fundamentally broke. There is a chance that a Zombie firm could restructure and save its business. For example, in the 2009 recession, the US government offered a subsidy to General Motors – which helped it to survive its near bankruptcy.

However, other economists suggest that it is generally inefficient to prop-up zombie firms as it keeps capital and labour inefficient and failing firms. Joseph Schumpeter argued that it is Creative destruction – of allowing zombie firms to go out of business that allows greater efficiency in the long-term. Bailing out zombie firms only props up inefficiency.

What causes firms to become a Zombie Firm?

  • High level of debt. If a firm takes on a high level of debt, then it is vulnerable to a rise in interest rates.
  • A period of very low-interest rates encouraging more debt. In the period 2009-16, interest rates around the world were very low – close to zero %. This encouraged firms to take on more debt. At very low rates, it is affordable to take on debt. However, very low-interest rates can encourage firms to take on debt that might be unsustainable, should interest rates rise.
  • Borrowing in a foreign currency. If firms borrow in a foreign currency, then they are vulnerable to a devaluation in the currency. For example, if Eastern European firms borrow in Euros, they might assume stable exchange rates, but if there is a fall in the value of the currency compared to the Euro, it effectively increases the domestic cost of servicing the Euro debts, and the cost of debt interest payments may become greater than their income.
  • Fall in demand. If a firm gets left behind by technology or a change in consumer preferences it can be left with unsold stock and wasted capital investment. For example, record companies may invest in new recording facilities and CD players, but the switch to electronic downloads took away their former business model and they were left with bad debts.
  • Exposure to bad debts elsewhere. In the lead up to the credit crunch, many European banks had a strong core business, but they purchased mortgage debt bundles from the US. However, they didn’t realise these debt bundles were actually full of sub-prime debts. When the US housing market fell, there was a rise in mortgage delinquency and these debt bundles lost their value. Banks were left with larger than expected losses.
  • Deflation. If a firm has high debt levels and there is a period of deflation, then this can increase the real value of debt repayments. They have to cut prices for their goods – due to deflation, but at the same time, their value of debt keeps increasing so it becomes progressively harder to meet the debt repayments.

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