Rescue solvent companies but kill off zombies

Former Chief Economic Advisor Arvind Subramanian said India had moved from socialism with limited entry (for firms) to capitalism without exit. Alas, capitalism without exit is zombieland, full of companies neither dead nor alive.

The problem has been intensified by Covid-19 and lockdowns. These have mortally wounded lakhs of firms that have then been rescued by loan moratoriums, loan guarantees, and evergreening of debts. This provides immediate relief but creates ever-more zombies.

Economist Joseph Schumpeter showed that “creative destruction” explained the success of market systems. Less productive firms were killed by competition. Their liquidation and auction of assets shifted land, labour and capital into more productive firms, constantly improving national productivity and prosperity. It also opened up economic space to newcomers.

The rescues mounted by the government and RBI will, rightly, save fundamentally productive firms, but also, wrongly, create many zombies. The government’s Rs 2 trillion rescue package is far from excessive. I have repeatedly urged higher deficit financing to help those in need. But I am equally clear that this orgy of deficit financing and loan waivers must be reversed next year.

Experience shows it is easy to open the fiscal and monetary taps but difficult to shut them later. The big tax cuts of 2008-09 raised the Centre’s fiscal deficit from 2.5% of GDP to 6.9%. This was worthwhile in a Great Recession. But it proved politically difficult to raise the taxes again to cut deficits. Political competition in freebies and subsidies kept the fiscal deficit high for a decade. Government investment was squeezed instead of soaring. No wonder the economy was slowing for more than a year even before Covid.

The best example of zombification causing economic stagnation is Japan. A fast-growing powerhouse till the 1980s, Japan suffered a financial crisis and recession in 1990. Rather than let companies sink, the central bank kept interest rates very low for and helped evergreen dud loans to companies. This reduced bankruptcies but created a myriad zombies. The economy revived in the 2000s when a global boom lifted all boats. But stagnation returned in the following decade of the 2010s. In desperation, the government raised deficit financing to record heights, lifting its debt/GDP ratio to a world record of 280%. Its central bank has started buying not just corporate bonds but even corporate equity to stimulate growth. This policy will, if continued for many years, make the central bank the top shareholder of major companies, an unwitting nationalisation. Even so Japan’s growth remains stubbornly low because of zombification.

Europe has gone in a similar direction in the last decade. The European Central Bank has printed enormous sums to buy bonds of sinking companies and countries. This has helped debt-ridden Greece and Italy survive but slowed European growth. Just as growth seemed to be reviving, Covid has sunk all boats.

The US has been the most dynamic of developed countries, but it too slowed considerably in the 2010s. The Fed printed trillions of dollars to keep the economy going. The result was the proliferation of companies living on rising borrowings rather than profits. The Fed began tightening money in the last two years ago, but the pandemic has forced it to return to printing money on a record scale, and even buying junk bonds. This will increase zombification. Deutsche Bank Securities estimates zombie companies in the USA have doubled in number between 2013 and 2020, from almost zero in 1990 when the Fed was more conservative.

India’s rescue package has been among the most miserly, insufficient to relieve immediate distress but controlling longer-term fiscal deficits and debt. Wisely, the stimulus has come mainly not from tax cuts that are difficult to reverse, but from RBI money-pumping schemes that are easier to reverse. Along with reversal, tough measures will be needed next year to avoid zombification.

First, the public sector banks must be massively recapitalised, and private sector banks asked to raise more capital. This alone will make them strong enough to write off massive, unrepayable debts caused by the pandemic, and start lending on a clean slate. In 2009, banks refused to frankly acknowledge and write off bad debts since that would have busted them. Instead they evergreened dud loans to cloak their plight, and kept zombies going. That error must not be repeated.

Second, the Insolvency and Bankruptcy Code must be amended to facilitate quick creative destruction. The IBC deadline of settling all cases within 270 days has become a joke because of lengthy litigation. Ways must be found to ensure to clear out deadwood fast, creating space for new companies. Many big names may disappear. So be it.

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