After Japanese stock prices peaked in 1989, stocks lost roughly 60 percent of their value in the next three years. Commercial land prices fell by roughly 50 percent after their 1992 peak over the next 10 years. Essentially, all loans that were secured by property became worth far less than anticipated. As a result, Japan's banking system failed to record a net operating profit for more than 10 years. Most importantly, economic growth ground to halt.
However, the political and regulatory response to the financial crisis was to deny the existence of the problems and delay serious economic reforms or restructuring of banks. Because banks had to comply with international standards governing their minimum level of capital, many banks continued to extend credit to insolvent borrowers, gambling that these firms would recover or that the government would bail them out. The Japanese government also encouraged banks to increase their lending to small- and medium-sized firms to ease the "credit crunch" after 1998.
The pattern of Japanese banks lending to insolvent borrowers, even when the prospects for being repaid were extremely doubtful, has been termed "ever-greening" in previous research. The practice of ever-greening became even more pervasive in the late 1990s and early 2000s.
In a new study "Zombie Lending and Depressed Restructuring in Japan," University of Chicago Graduate School of Business professor Anil K Kashyap, Takeo Hoshi of the University of California at San Diego, and Ricardo J. Caballero of Massachusetts Institute of Technology explore the role that misdirected bank lending played in prolonging Japan's economic stagnation. The authors focused on the widespread practice of Japanese banks lending to unprofitable borrowers that the authors refer to as "zombies."
Previous research has found that bank loans to poor performing firms often increased between 1993 and 1999. For all publicly traded firms in the manufacturing, construction, real estate, retail, wholesale, and service sectors, 30 percent of these firms were on life support from banks in the early 2000s.
Kashyap, Hoshi, and Caballero began with the premise that most large Japanese banks only complied with capital standards because regulators were lax in their inspections. Banks often engaged in sham loan restructurings that kept credit flowing to "zombie" firms, which under normal conditions would be forced to shed workers and lose market share. Low prices and high wages reduced the profits that new and more productive firms could earn, thereby discouraging their entry and investment.
Focusing on the effects of zombie firms partially explains why the combination of extremely low interest rates and large budget deficits did not revive the economy. Neither policy focused on closing down the insolvent banks and the zombie borrowers that strangled the economy.
"Our most noteworthy result is that the presence of the zombie firms infected healthy firms by creating ongoing distortions that lowered job creation and industry productivity," says Kashyap.
The distorting effects of zombie firms included lowering market prices for their products, raising market wages by hanging onto workers whose productivity at the current firms declined, and congesting markets where zombie firms participated.
"What happened in Japan shows the dangers of not regulating banks carefully and not forcing zombie firms out of business," says Kashyap. "By taking a very short-term view of the economic crisis, politicians and regulators kept everybody stuck in the wrong place."
Creative Destruction or Lack Thereof
According to the theory of "creative destruction," much of the progress in a market economy takes place through restructuring. Unproductive firms go out of business and new, more efficient firms replace them. Under normal conditions, zombie firms would have gone bankrupt and been replaced by new and better business ideas and models.
"Usually when an industry is hit by a bad shock, many firms exit," says Kashyap. "In Japan, firms never exited. Given that they never exited, it is not surprising that new firms weren't created."
When bankrupt firms continue to operate, they hang onto workers who would otherwise be willing to work for lower pay at a healthy firm. Thus, it is more expensive for new firms to operate, and as a result, fewer new businesses enter the market.
Kashyap adds, "By recycling loans, banks essentially doubled and tripled their bets on these zombie firms. If banks had cut their losses back in 1994 rather than consciously ignoring the problem until 1997, the situation would not have been nearly as bad."
Kashyap argues that regulators should have forced banks to recognize they were undercapitalized and needed to raise money, and face the consequences of poor performance. Instead, there was a serious discrepancy between regulators denying the severity of the banking crisis and the significant amounts of taxpayer money being spent to prop up the ailing banks.
"The government allowed even the worst banks to continue to attract financing and support their insolvent borrowers," says Kashyap. "By keeping these unprofitable borrowers alive, banks allowed the zombies to distort competition throughout the rest of the economy."
Looking for Zombies
To study the effect of zombie firms on the Japanese economy, Kashyap, Hoshi, and Caballero began by classifying firms that were being kept alive with direct interest rate subsidies. Specifically, zombie firms were defined as those firms whose borrowing costs were so low that the only possible explanation for the low rates was that the banks were subsidizing them. This conservative definition likely understates the number of zombies since only firms getting extraordinary amounts of support would be detected. Nonetheless, the prevalence of firms getting assistance is staggering.
The percentage of zombie firms hovered between 5 and 15 percent until 1993 and then rose sharply over the mid-1990s so that the zombie percentage was above 25 percent for every year after 1994. The proportion of zombie firms increased in the late 1990s in every industry, though the problem was more serious for non-manufacturing than manufacturing firms.
The authors next analyzed firm-level data to study the congestion effects of zombies on the behavior of healthy firms. The authors find that investment and employment growth for healthy firms fell as the percentage of zombies in the industry rose. The gap in productivity between zombie and healthy firms rose as the percentage of zombies rose. The presence of zombies depressed activity the most for the fastest growing healthy firms.
Zombie firms lower an industry's average productivity both directly by continuing to operate and indirectly by deterring the entry of more productive firms.
"A healthy firm competing against a subsidized firm will be in trouble because in order to expand the business, the healthy firm must overcome the subsidy," says Kashyap.
The authors find that bank lending distortions were not equal across all sectors. In addition to zombie firms, the construction and real estate industries had to confront the huge run-up and subsequent collapse of land prices. Problems were less acute in the manufacturing industry.
Compared with a normally functioning economy, the authors find that the existence of zombies softens the shock of an economic downturn on job losses, but this temporary benefit is more than offset by the depressing effect on job creation. This distortion depresses productivity by preserving inefficient units at the expense of more productive potential entrants.
The cumulative size of distortions in investment and employment is substantial. "Our most important result is that we do find job destruction and the elimination of businesses falling sharply in industries where there are many zombies," says Kashyap. "Businesses are not exiting, and new ones are not created."
The most compelling evidence for this link, Kashyap explains, is that healthy firms find it less attractive to invest in industries where there are more zombies. This goes against conventional wisdom, because healthy firms would normally want to expand their business in industries with ailing firms. Even a firm with strong sales growth is less likely to invest or add workers in industries where there are many zombies.
According to the authors, the restructuring of the financial system was necessary for sustained economic recovery. With banks finally having become profitable again, it is possible that they will no longer be willing to keep the zombies alive.
While this is not yet settled, Kashyap argues that, "The experience in Japan definitely shows that providing subsidized credit to dying firms will be costly over time. Keeping an industry from restructuring only delays the day of reckoning and raises the cost substantially."
The authors' description of the Japanese experience mirrors the early phases of the transition of many former socialist economies to becoming market-oriented. These economies, such as Russia in the 1990s, also have dealt with the continued operation of state-owned enterprises hindering the development of the private sector. Given the fragile condition of China's banking system and its commitment to keep workers employed, the situation in China bears close watching according to Kashyap.
Key to the authors' theory about zombie firms is the lack of restructuring, which also may be caused by legal bankruptcy procedures that protect debtors. The problem is not unique to Japan. For example, in the U.S. airline industry it is routinely argued that the industry has been plagued because unprofitable carriers go bankrupt, but fail to exit the industry.
"It is not surprising that private firms do not want to compete with state-owned firms," says Kashyap. "The private company knows that the state-owned company will keep operating and lower prices if they have to, even if it makes no economic sense. There are many examples besides Japan where people fail to recognize that it is dangerous to keep people attached to businesses that are fundamentally unprofitable."