The Strategist

Zombie companies threaten the economy of Europe

11/24/2017 - 04:30

Hundreds of loss-making and heavily indebted companies in Europe, especially in the southern countries, remain afloat thanks to the financing of banks and shareholders. According to economists and central banks, such zombie companies create artificial barriers to entry into markets, and their competitors are forced to cut prices. The economy cannot be cleared of weak companies and problem loans, which usually occurs after crises.

"The zombification of the corporate sector and banks threatens the future standard of living," says Klaas Knot, the head of the central bank of the Netherlands.

A "zombie" is a public company that is at least 10 years old and whose interest payments on loans exceed profits before interest and taxes, according to the definition of the Bank for International Settlements (BIS). The ECB says that about 10% of companies in the six leading countries of the Eurozone are "zombies". In 2007, there were only 5.5% of them. The OECD reports that the share of such companies has tripled in Italy and Spain since 2007. In Italy, about 10% of the working population is employed by a "zombie", and they received 20% of all invested capital in 2013.

To some extent, the reproduction of "zombies" has become a side effect of the ECB's soft monetary policy. Some of the rich countries of the Eurozone have sharply criticized negative interest rates and other incentive measures to support problematic corporate borrowers. According to the OECD, they received about 10 billion euros from banks only in Spain and Italy in 2008-2013. In late October, the ECB said it would continue the program for buying bonds until September 2018. It is unlikely that it will raise interest rates before 2019.

Existence of the "zombies" is partly associated with a decline in productivity in Europe, say economists. Thus, cement production in Italy decreased by 60% from 47 million tons at the peak in 2007, while the number of cement producers in the country decreased during this time from 29 to 24 at the end of last year. Many of these companies continue to exist due to "financial doping", says Francesco Caltagirone Jr., general director of Cementir Holding, one of the industry leaders.

A vivid example of a "zombie" is the German shipping company Norddeutsche Vermoegen. Its debt grew 4 times to more than $ 2 billion in 2007-2010, and exceeded revenue by 9 times. The cumulative loss was $ 1.1 billion in 2010-2015. The company did not submit financial results for 2016, but stated that it had made a profit by writing off debt of approximately 500 million euros by HSH Nordbank. About 90% of the bank belongs to the authorities of the states of Schleswig-Holstein and Hamburg. Therefore, local taxpayers can suffer, says opposition member Michael Kruse.

The financial crisis hit the world trade and shipping companies, and some of them were unable to repay their debts. According to Moody's, in Germany, about 37% of loans issued by the largest creditors of shipping companies - or $ 26 billion - are problematic. However, there were few bankruptcies in the industry in the country, which indicates the willingness of banks to support weak companies.

On the other hand, the banking sector of Italy is facing great difficulties now. About 15% of loans issued by banks are problematic. To compare, their volume amounts to about 6% in the whole euro area, and is less than 2% in the USA. According to the Italian central bank, the total problem loans were $ 407 billion at the end of 2016 and local banks allocated half of that amount to cover them. In October, the ECB suggested demanding banks to increase reserves. However, Italian politicians have criticized this proposal. As former Prime Minister Matteo Renzi said, if the new rules are adopted, "lending to small businesses will become impossible." Some banks in Italy began to solve the problem and announced plans to sell troubled loans for billions of euros in the next three years. According to Morgan Stanley estimates, the country's banks will need 10 years to raise their troubled loans to the average for the euro area.

A change in the laws on bankruptcy can help to get rid of "zombies" and problem loans, analysts say. However, attempts to introduce in Europe an analogue of Chapter 11 of the US Code of Bankruptcy, allowing the reorganization of companies, turned out to be ineffective. Therefore, economists warn that these attempts can, on the contrary, increase the number of "zombies", but not improve the companies’ condition.

For example, in 2012 Portugal developed a program to help companies reach an agreement with creditors to avoid bankruptcy and invest in business growth. In practice, however, the program does not help banks prevent the emergence of "zombies", notes a professor of ISEG. It allows banks to report unwritten debts of companies as normally repayable, so it encourages them to write off as few debts as possible.