Zombie companies may eventually go bankrupt due to the Bank of Japan's interest rate hike

After implementing ultra-loose monetary policies for 30 years, even a slight interest rate hike by the Bank of Japan could lead to an increase in the number of zombie companies, potentially driving them into bankruptcy.

A report released earlier this month by Tokyo Shoko Research showed that for the first time in a decade, the number of corporate bankruptcies in Japan exceeded 5,000 from April to September this year. These 5,095 companies had a total debt of nearly 13.8 trillion yen ($9.2 billion), with the largest portion coming from the service industry.

Zombie companies are defined as businesses that struggle to pay interest on their debts with operating profits alone. Due to low interest rates and government support, these companies have survived in Japan for years. Unable to invest or hire, they stifle the emergence of new businesses and hinder job mobility. Nicholas Smith, a strategist at CLSA Securities Japan Co., said that clearing these companies might not be a bad thing, as it could pave the way for new, healthier businesses.

"We won't miss a beat," Smith said. "The current situation is that we're not worried about unemployment in Japan. In fact, our biggest concern is a severe labor shortage."

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According to a report by the research firm earlier this year, a 0.1 percentage point increase in the benchmark interest rate could increase the number of these zombie companies from around 565,000 to around 632,000. Most of the profits of these companies are used to repay debt.

One such company is HIS Co., one of Japan's largest travel agencies. The Tokyo-based company achieved an operating profit of 1.4 billion yen in the last fiscal year ending in October, but had a net interest expense of 1.5 billion yen.

Known for its low-cost travel packages, HIS has been struggling due to the lack of outbound travel from Japan after the pandemic, in stark contrast to the influx of tourists visiting the country. This is partly due to the weak yen, another legacy of decades of low interest rates. According to data compiled by Bloomberg, after 2020, HIS took on more debt and currently holds 30 billion yen in debt.

In 2008, three professors, including Takeo Hoshi, a professor at the University of Tokyo, coined the term "zombie companies." He defines zombie companies as those that have not resolved operational issues but avoid bankruptcy due to financial support from the government or creditors.

On the other hand, the Bank for International Settlements defines them as companies that have been established for more than 10 years, have an interest coverage ratio below 1, and have maintained this for more than 3 years.

One of the largest bankruptcy cases this year is MSJ Asset Management Co., which held 641.3 billion yen and was liquidated by Mitsubishi Heavy Industries Ltd. after failing to enter the domestic passenger aircraft business.Other companies include the plastic recycling firm Eco Research Institute Ltd., medical equipment supplier Hokushin Medical Co., and Asahi Food Create Ltd., which sells pre-packaged food products.

Apart from banking and insurance, every industry and region in Japan has seen an increase in bankruptcies over these six months. With interest rates on the rise, and key industries such as transportation, artificial intelligence, and software facing fierce competition from global enterprises, this number is set to grow further.

Even large Japanese companies are not immune to the prospect of bankruptcy. Panasonic Liquid Crystal Display Co. tops the list of bankruptcies in 2023. Competition forced the LCD panel business to shift its focus to automotive and industrial sectors, but trade tensions between the US and China led its parent company to close the business.

Panasonic Holdings Corp. decided to liquidate the assets of the division and write off a 583.6 billion yen loan it owed to another subsidiary. The company adopted a holding company structure in 2021, aimed at improving accountability and profitability across its divisions. In May of this year, the company's CEO, Yuki Kusumi, stated that he would improve underperforming divisions by finding the "best owner" for them.

The number of debt-ridden Japanese companies is growing rapidly, even faster than the increase following the bursting of the asset price bubble in 1992 in some respects. According to Tokyo Shoko Research, zombie companies make up 14% of Japanese listed companies.

"Zombie" companies are concentrated in industries with the most severe labor shortages in Japan, such as restaurants, hotels, transportation, and tourism.

A non-productive company cannot maintain employment and competitiveness; it cannot buy or sell, and of course, it cannot make a profit. Especially outside of metropolitan population centers, the continuous struggle of companies makes investment difficult.

However, decades of cheap credit and generous handouts have created a generation of companies with shaky balance sheets and low productivity. During the pandemic, the Japanese government injected trillions of yen into such businesses—some experts believe that these "interest-free, unsecured" loans may be the main catalyst for the recent surge in bankruptcies.

When a small or medium-sized company goes bankrupt, their employees are free to seek jobs elsewhere, hopefully in a company with higher profits, higher productivity, and better balance. If anything, this is a natural byproduct of the Bank of Japan's interest rate hikes (if not intentional), and it may help alleviate the ongoing labor shortage caused by Japan's aging and shrinking population.

Naoki Hattori, a senior economist at Mizuho Research & Technologies Ltd., said, "The Japanese economy is reaching a turning point, and we need to change our way of thinking."Naoki Hattori said that an increase in bankruptcies is inevitable, but this does not mean that all these companies should be left to fend for themselves. He added that the challenge lies in determining which companies can be helped and how to help them. Each business is unique and requires a tailored approach, and some experts believe that local financial institutions are in the best position to do this.

"Our goal is not to increase bankruptcies. The goal is to reduce debt," said Mitsuhiro Harada, head of research at Tokyo Shoko Research, "To a large extent, this is to protect our way of life."

So far, it seems unlikely that the Bank of Japan will be in a hurry to raise interest rates. Although the Bank of Japan maintained its monetary policy unchanged last month, Hattori expects the Bank of Japan to raise interest rates to 0.5% at some point between January and March. This would be the highest level since the early 1990s and could further indebt or bankrupt many companies.

Smith of CLSA said that as interest rates rise, the yen will strengthen, thereby reducing inflation and giving consumers some breathing room.

"Of course, it's stressful, but the rest of the world has to deal with it," Smith said, "Overall, the economy performs much better with higher interest rates."