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1 1 (October 29, 2020)

handle is hein.crs/govdcin0001 and id is 1 raw text is: October 29,2020 Zombie Companies: Background and Policy Issues Zombie companies are mature companies thathave not generated sufficient profits to cover their debt borrowing costs over aperiod ofyears. Such companies are characterized by prolonged underperformance and poor future prospects and are often associated with low productivity. The number ofzombie companies has goneup in recent years. As many as 15% of companies in the Russell 3000-an indexof 3,000 publicly traded U.S. companies that make up the vast majority of the investable public U.S. equity market-are considered zombies by some (Figure 1). This In Focus addresses basic questions about zombie companies, discusses their effects on the economy, and briefly reviews policy implications and proposals to address them. Figure I. Percentage of U.S. Zombie Companies in Russell 3000 Equivalent Index T^,,... r x Source: Leuthold Group and Joe Rennison,Pandemic Debt Binge Creates New Generation of Zombie Companies, Financial Times, September 13, 2020. Notes: Companies with profits that are less than the interest paid on their debts for at least three years. Data based on the Leuthold 3000 Universe (a Russell 3000 equivalent) as of September 2020. Whe isa Co pn Z m&? Definitions ofzombiecompany can vary. Unprofitable companies are not automatically zombies. For example, companies facing temporary earnings challenges, such as young growth companies or companies that are going through ares tructuring phase, are generally not considered zombies. The Bankfor International Settlements (BIS), an internationalfmancialinstitutionforcentralbanks, offers a broad and a narrow definition ofthe term. The BIS's broad definition encompasses firms that have interest-coverage ratios below one for at least three consecutive years and are at least 10 years old. The narrower definition incorporates these screening criteria but excludes firms with certain financial characteris tics thatplace themin the upper half of their indus tries in a given year. Specifically, the ratio between the market value of a firm's as sets and their replacement cost (the sumof the market value of equity and liabilities divided by the sumofthe bookvalue ofequity and debt) mustbe below themedian for the firm's s ector in any given year. Accordingly, the BIS definition makes clear that a company is not a zombie merely because it is unprofitable. Rather, zombies must demonstrate sustained unprofitability and poor future prospects. Whatsh Harm? One of the main economic concerns regarding zombie firms is low productivity, which in turn can lead to low economic growth. Because zombie companies' profits cannot cover their debt servicing costs, they generally cannot invest in future growth through activities such as research and development. Zombies can also tie up capital and labor, preventing themfrombeing allocated toward higher-growth opportunities. They are therefore viewed as inhibiting creativedestruction, atermfirstintroducedby economist Joseph Schumpeter in the 1940s to refer to the process in a free economy in which insolvent companies are destroyed to make room for otherhealthier and more productive companies. While the methods to keep zombies afloat vary, some observers believe thatunless such methods canprovide a fundamental cure for low productivity and profits, temporary fixes merely delay insolvency. Furthermore, as zombies proliferate, they could become financial stability concerns: If economic conditions deteriorate or interest rates rise, zombies may file for sudden bankruptcies with effects that cascade throughoutthe broader economy. The number of zombies has increased in recent years, including during the Coronavirus Disease 2019 (COVID- 19) pandemic (Figure 1). Factors that may have contributed to the formation ofnew zombies include reduced profits at pandemic-affectedbusinesses and improved credit conditions, including low interestrates, easy availability of funding, and direct government intervention. In addition, existing zombies are remaining in their zombie status for longer, likely because fewer zombies than expected have taken exits through bankruptcies and takeovers. Government interventions that improved funding conditions. Government interventions in response to the pandemic have supported the survival of many companies, including zombies. For example, the pandemic triggered a corporate debt market meltdown in March 2020. Borrowing became prohibitively expensive, andnew corporate bond is suances came to a near standstill. The U.S. Federal Reserve and the Treasury Department provided historic support to credit markets, including unprecedented steps to agree to purchase corporate bonds and bond exchange- traded funds. Following directcapital market interventions and fiscal support fromCongress, corporate borrowing \ Q

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