[The Editors' Verdict] Zombie Companies Spawned by the Pandemic

Kim Kyung-soo, Professor Emeritus at Sungkyunkwan University

More than two months have passed since the global pandemic began. As the economy came to a halt, fractures have appeared in vulnerable links. Corporate bankruptcies have started. Among industries with blocked cash flows such as retail, energy, and hospitality, the number of bankruptcy protection filings has sharply increased, especially among highly indebted companies, and Korean companies are also noticeable on websites listing large corporations at high risk of bankruptcy.

Professor E. Altman, who has dedicated his life to studying distressed companies, stated in an interview with a media outlet that even before the outbreak of COVID-19, the fundamentals of American companies were fragile, and many companies that were cheaply using credit were actually 'zombie companies' that should have gone bankrupt. Professor Altman is the person who developed the Z-score 50 years ago to measure the probability of corporate bankruptcy.

He predicted that many companies downgraded due to the pandemic are on the brink of bankruptcy and that corporate bankruptcies will peak in 2021. Recently, The Economist reported his forecast that within one year, 8% of the 1,900 speculative-grade companies in the U.S. will go bankrupt, rising to 20% over two years.

The fate of companies breaks when they are in the wrong industry at the wrong time or fail to properly prepare for circumstances, as is the case now. Over the past decade, the S&P 500 index rose 170%, but among the 11 sectors included in this index, the energy sector fell nearly 30%. Cyclical discretionary consumer goods, which are sensitive to economic fluctuations rather than essential consumer goods, rose about 300%, but even within the same sector, automobiles and e-commerce differ vastly. The IT sector, which rose nearly 400%, accounts for more than 26% of the total market capitalization of S&P 500 large companies. The industrial sector, including machinery and equipment, which can be considered Korea’s main industries, rose only about 100%, clearly entering a downward path, and currently accounts for only 7.5% of the total market capitalization.

This trend clearly shows that capital markets are the driving force behind industrial restructuring and the primary factor determining corporate fortunes. As experts predict, if the pandemic shrinks the global value chain (GVC) and acts as a catalyst accelerating the digital revolution and automation, such industrial restructuring will occur even more strongly.

According to the Bank for International Settlements (BIS), at the end of last year, the debt of the non-financial sector relative to GDP was high among major countries in the order of Japan (380.7%), China (258.7%), the U.S. (254.2%), and Korea (237.2%). Among these four countries, the government debt is highest in Japan (217.8%), corporate debt is highest in China (149.3%), and household debt is highest in Korea (95.5%). Corporate debt in Korea (102.1%) is significantly higher than in the U.S. (74.9%). Both households and companies entered the pandemic burdened with heavy debt. The Bank of Korea also pointed out the deterioration of corporate financial soundness in its financial stability report at the end of last year. Regardless of company size, debt increased, profitability declined, and interest payment capacity deteriorated.

This year, the three major international credit rating agencies have downgraded or given negative outlooks on the credit ratings of 45 large domestic companies. Domestic credit rating agencies have done the same. Ultimately, it seems inevitable that many companies, large and small, will face bankruptcy risks going forward. Although the direct damage from the pandemic was not large, Korea’s economy, which has become vulnerable in export competitiveness due to failure to properly transform its industrial structure, is expected to suffer significant indirect damage.

Financial authorities must carefully examine any obstacles to smooth corporate restructuring and swift corporate rehabilitation procedures and improve related laws and systems. Otherwise, zombie companies may further damage the already fragile corporate ecosystem.

Kyungsoo Kim, Professor Emeritus, Sungkyunkwan University