Financial support during the pandemic: The rise of the zombie firm in the Netherlands
Financial support during the lockdown could create more marginally profitable or zombie firms. The longer the crisis, the higher this trend. Are there any simple solutions?
The COVID-19 crisis has serious consequences for business. Due to the ‘intelligent’ lockdown in the Netherlands, many companies suddenly faced a loss of sales – sometimes even nil sales! – and saw their cash flow dry up. This has caused serious liquidity problems and the threat of bankruptcy for many firms. This contagious and systemic effect could seriously hamper the economy, even once the crisis is over. Therefore, governments indeed had no other option than to mitigate a possible macroeconomic shock by classifying this crisis as a non-normal business risk. It is thus fair and reasonable that governments have generously facilitated the business community through all kinds of financial support schemes to promote the continuity of firms.
But the danger of this bolstering policy is keeping alive marginally profitable firms that in the post-coronavirus era will not be viable. Besides, financial support could reduce the incentive to adapt to the new economic reality and could undermine the necessary creative destruction to vitalize the business sector. The longer the period of financial support, the more severe this effect will be. Therefore, there are hidden costs to financial support during the pandemic which could hamper the competitiveness and productivity of a country in the long run.
The business sector – in terms of productivity and profitability – contains many poor or underperforming firms; only a tiny fraction of firms are outperformers. The productivity of a country depends on the way resources are allocated to firms; the more resources are allocated to marginally productive firms, the lower the productivity of a country. This tendency – a rising proportion of marginally performing firms in the business population – is called ‘zombification’. What is it exactly and what are its causes, consequences, and solutions?
A Zombie firm
A zombie firm is a marginally productive and profitable firm that can stretch its existence. It is a firm that has existed for at least ten years and has realized insufficient Earnings Before Interest and Taxes (EBIT) to cover the interest expense for three consecutive years (this means that its interest coverage ratio is below 1, Bank for International Settlements, BIS). Zombification was first noticed in Japan during the recession in the nineties. Japanese banks were hesitant to write off their bad debts and therefore did not liquidate firms.
Based on this definition, the BIS draws a disturbing conclusion: there is an increasing trend concerning the proportion of zombie firms, for some countries up to even 15%, while this percentage was 4% in the early 1990s. In the Netherlands, Gun and de Winter (2020) calculated that the percentage of zombie firms is rather low (< 3%) and that from 2003-2017 – the pre–coronavirus age – this percentage had not increased. But what about the post-coronavirus age?
Causes for the increase in zombie firms
Banks perhaps fear writing off their loans – giving huge losses in their income statement – but it also possible that banks are hesitant to liquidate firms because they are giving them – due to the incidental and sudden character of the crisis – the benefit of the doubt. A recent publication by the Nederlandse Vereniging van Banken (NVB) mentions that 129,000 firms have been granted a delay in their payment obligations.
A second cause is financial support from the government. The various current facilities in the Netherlands add up to 60 billion euro and this figure is still rising. The sum for the delay in tax payments, alone, is around 17 billion. Due to this support, the operational profits of non-financial firms even increased by 3 billion during 2020! Due to less profits from foreign subsidiaries, however, gross profit did decline, but only by 4% (DNB, 2021). Despite the COVID-19 crisis, the number of firms that have gone bankrupt is the lowest in 21 years (DNB, 2021).
One dormant cause is the monetary policy of the European Central Bank. Because of the low interest rates, firms must be barely profitable to survive. Due to these low interest rates, firms are less disciplined by capital markets.
Finally, it could be that the legal mechanisms for reorganising poorly performing firms at an early stage are inadequate. Recently the Wet Homologatie Onderhands Akkoord (WHOA) (Court Approval of a Private Composition (Prevention of Insolvency) Act) was introduced in the Netherlands. Facilitating an earlier way of reorganising could reduce the number of zombie firms. However, it could also lead to a stay of execution for zombie firms. In an empirical study, the BIS concluded that reorganised zombie firms showed poorer performance than average after reorganisation and have a higher chance of becoming a zombie firm again.
Consequences of a rise in zombie firms
Entrepreneurship is no guarantee for success. The viability of a firm is the outcome of an uncertain and capricious market process. The essence of value creation and capturing is its uncertainty. This is shown in the dispersion of productivity of Dutch firms. The BIS has calculated that a rise in zombie firms of 1% in the total population of firms, lowers productivity growth by 0.3%. On the one hand, zombie firms can frustrate the smooth reallocation of resources to more productive firms; on the other hand, due to lots of poorly performing firms, other firms do not feel the need and pressure to innovate. Besides, financial support freezes the economy and this hampers adaption to the new post-pandemic age.
No clear solutions – failure is the norm in various guises
There is no easy solution for this problem, but it will become more severe the longer the financial support is provided. That said, the timing for phasing out the scheme will be difficult. It has also been suggested that only viable firms should be supported longer. But the problem is that selecting the viable, value-creating firms is extremely difficult. There is a possibility that the wrong firms will be selected. Besides, individual support is highly subjective, arbitrary and manipulative. A report by the Rekenkamer (2020), questions individual firm support and concludes that: ‘Doing nothing is a serious option’. So governments often fail, just like firms do. But markets fail too, and the fascinating thing is that in most theories of the firm that is actually the reason that firms exist…
Of course, no one is waiting for a wave of bankruptcies, but a more natural change in the number of firms might be socially desirable in the long run. More dynamics in the business population could create a more competitive and welfare-enhancing economy. But there are no simple solutions!