Zombification in India: A Fallout of COVID-19 Rescue Mechanisms?

India’s shift from “socialism with restricted entry” to “capitalism without exit”, as our former chief economic advisor Arvind Subramanian had described it, has resulted in the creation of “zombie” companies. Zombie companies are poorly performing companies, incapable of servicing their debts from current profits and which consequently rely on readily available low-cost debt financing for their continued existence. This concept of zombie companies emerged post the famous zombie outbreak in Japan, in the 1990s, where unprofitable companies were widely prevalent due to the “evergreening” of loans by Japanese banks. Such zombification, as studies suggest, tends to lower productivity and growth of the industries that these companies are a part of, depress profits and job creation, and divert scarce resources, including capital and labor from other healthy companies, thus creating barriers to entry and also resulting in economic stagnation. Furthermore, according to another study, the growth of healthy companies was found to be much slower in countries with a larger number of zombie companies. It was also found in a study that with every 1 percent increase in the share of zombie companies, the capital expenditure rate and employment growth of non-zombie companies reduced by 1 percent and 0.26 percent respectively. This article would analyze the effects of monetary and fiscal measures undertaken to stimulate the economic growth, in response to the outbreak of the Covid-19 pandemic, on the creation and sustenance of zombie companies in India.

Covid-19 has sparked a global pandemic that has given rise to several economic challenges for India. The nation-wide and state-wide lockdowns leading to supply chain disruptions have halted almost all economic activity in the country, injuring the profitability and viability of business firms. While the rescue package released by the Government of India and the Reserve Bank of India (“RBI”) in terms of loan moratoriums, credit guarantees, relaxation of bankruptcy laws, and repeated refinancing may provide immediate relief and rightly save productive and viable firms facing temporary liquidity shocks, it can also wrongly lead to the creation and sustenance of zombie companies through mis-allocation of resources. By pushing debt into non-viable firms, the rescue mechanisms have caused resources to be tied up in firms which cannot generate corresponding economic value. While such emergency measures were necessary to prevent massive unemployment and business firms from going under losses due to the financial distress caused by the pandemic, they would prove to be counter-productive, as it happened in 2008-09, as explained below, if they continue beyond the emergency period without mechanisms in place for their reversal.

A study highlights how improperly designed temporary forbearance measures may have persistent negative effects on industries due to an increased zombie lending. The major tax- cuts imposed by the Government of India in 2008-09 to stimulate the economy hit by the Great Recession, proved to be politically difficult to reverse, resulting in an extremely high fiscal deficit for around a decade. This was accompanied by evergreening of faulty loans by banks refusing to acknowledge and write-off bad debts in order to window-dress their underlying capital erosion, effectively engaging in a phenomenon that Raghuram Rajan termed as “extend and pretend regime.” Such repeated refinancing of defunct firms by weak banks exploiting the forbearance window is one of the major reasons for the creation and sustenance of zombie companies.

In order to avoid the practice of window-dressing by weak banks debilitating the entire economic system of India, the RBI would need to ensure that once the pandemic ends and the forbearance measures come to a halt, there is a thorough clean-up of the balance sheets of banks, in addition to recapitalization of the banking system (to write-off massive non-performing assets) and a comprehensive asset quality review accounting for the methods of evergreening dud loans. Indiscriminate lending to zombie companies has also been attributed to weak governance in the banking and auditing systems, thus necessitating strong governance mechanisms to prevent window-dressing and zombie lending in the future.

Wisely, however, the government has not undertaken significant tax cuts as a relief measure, which has proved to be difficult to reverse in the past. On the other hand, the deficit financing is expected to reach a record high of 7.6% of the GDP for the financial year 2021 and thus, would have a long-term control over the economy. Furthermore, the acceleration of low interest rates due to the pandemic has further enabled zombie companies to continue surviving on easy credit rather than to exit the market. These interest rates are further expected to remain low for the next couple of years, consequently reducing financial pressure on the zombie companies and encouraging them to avoid restructuring for years to come. Furthermore, once the circumstances of deficit financing, loan waivers, and easy credit end, these non-viable companies will let go of employees, presumably resulting in pressure from the general public and even political parties to keep interest rates low indefinitely.

Nikkei Asia Review ranked India as the leader in Asia, for the year 2018, with a total of 617 zombie companies accounting for 26% of the total companies examined in India. It further observed that major power companies including Reliance Power and Adani Power were among the top companies with an increased debt in India. These numbers are indicative of the failure of the free-market forces to eliminate unproductive and unprofitable firms from the economy. A healthy economy is characterized by the ability of productive and new companies to replace insolvent and unproductive companies. According to the Bank for International Settlements, in an economy, for every 1 percent rise in the number of zombie companies, there is a 0.3 percent fall in productivity growth. Thus, arguably highlighting the need for “creative destruction”, as conceptualized by the Economist Joseph Schumpeter, for improving the productivity of the national economy by shifting resources including land, labor, and capital, from the eliminated firms (through liquidation of assets) to more productive firms and healthy firms.

In India, the Insolvency and Bankruptcy Code, 2016 (“IBC”) is the legal framework available for quick destruction of non-viable firms. However, the 270 days limit (revised to 330 days) for completing the Corporate Insolvency Resolution Process has proved to be a setback in light of the prolonged litigations undertaken. As a response to the pandemic, the threshold for triggering insolvency proceedings was increased, in addition to suspensions on initiating insolvency proceedings, further intensifying the problem of zombie firms by restricting creative destruction. While the relaxation of the IBC laws is certainly a relief for companies, mechanisms have to be in place to ensure that it does not compromise the ability of the banking system to recover its dues. The threat of initiation of insolvency proceedings has been a significant tool with the bankers to influence willful defaulters to restructure or resolve their faulty loans. The relief could have the unintended effect of exempting zombie companies, keeping afloat on borrowings from insolvency proceedings, if they just happen to default on loans during the suspension period. The relief measures could also be understood to prevent voluntary insolvency proceedings during the suspension period, inevitably promoting zombification by forcing non-viable companies to survive on life-support. Therefore, it is important to consider if there has been a restricted advisory against the initiation of insolvency proceedings against fresh defaults caused by Covid-19, as opposed to a complete stoppage on all insolvency proceedings. There is, however, a need for amending the IBC to facilitate quick and creative destruction to create room for new and healthy firms.

While the rescue mechanisms designed to keep the Indian corporate sector afloat until the end of the pandemic, have met their intended effect of ensuring that a huge wave of commercial bankruptcies does not occur, the mechanisms could be held responsible for holding insolvent and non-viable companies on life support, if the policy-makers and RBI fail to strengthen their structural weaknesses and impaired banking systems. Furthermore, there is a need for both, the reversal mechanisms as well as specialized measures, to rectify the zombification caused by the pandemic rescue packages. While regulatory forbearance is necessary, there have been almost no restrictions regarding who receives its benefits. Therefore, restrictions on lending to zombie companies could then prove to improve the borrowing culture in India and prevent regulatory arbitrage.