Did COVID-19 create more zombie firms in Japan?

Gee Hee HONG

ITO Arata
Senior Fellow, RIETI


SAITO Yukiko
Senior Fellow (Specially Appointed), RIETI

With low levels of firm exits, it appears that Japanese firms have weathered the pandemic. However, aggregate firm exit rates mask developing corporate vulnerabilities due to: (i) weaker cleansing mechanism with the decline in the exit of unhealthy firms; and (ii) increased borrowing, especially in long-term debt. The pockets of vulnerabilities are concentrated in sectors most affected by the pandemic, with a sharp increase in the number of firms with solvency issues (“zombie firms”), which would have otherwise been healthy firms without the pandemic.

Two years have passed since the COVID-19 pandemic shock permeated the globe. The pandemic constituted a massive shock to the Japanese economy, as in other countries, posing a significant threat to the business continuity of firms. With timely and strong government support, firm exit rates have remained remarkably low and job losses associated with the pandemic have been contained. At the same time, the low level of firm exits raises concerns about the zombification of Japanese firms, to the extent to which the government support is allowing insolvent firms to continue, and the extent to which previously healthier firms became vulnerable after the pandemic shock.

In this column, using a firm-level dataset from Tokyo Shoko Research (TSR), a credit rating agency, on firm exits and balance sheets up to 2021, we document the impact of the COVID-19 pandemic on corporate exit patterns and debt structure. First, we examine the correlation between firm characteristics and firm exits before and after the pandemic shock. This addresses the question of which firms have exited in the past two years. In addition, we look at this correlation for different firm exit types (voluntary exit versus bankruptcy), taking advantage of the information available in the data. Second, using balance sheet information, we document the change in corporate debt structure. Using the definition of “zombie firms” introduced by Fukuda and Nakamura (2011, 2013), we identify firms that have built up corporate debt beyond their ability to repay.

In a recent paper (Hong et al., 2022), we find that the low level of firm exit rates indeed masks increased corporate vulnerabilities, especially in sectors that were most directly affected by the pandemic. Importantly, firm exit rates of financially weak firms declined during the pandemic, suggesting that the so-called cleansing mechanism, whereby a less productive firm exits to allow for a more productive firm to enter, has weakened (Note 1). At the same time, the bankruptcy rate has declined for all firms, regardless of their financial conditions. Turning to the changes in corporate debt structure, we find that firms increased long-term borrowing as opposed to short-term borrowing. Corporate debt increased by 9.4 percent in 2020 at the aggregate level, but a substantial increase was concentrated in certain sectors, mostly exposed to the pandemic shock, but also in the manufacturing sector. The share of zombie firms rose sharply in the accommodation, personal services, and transportation sectors as well as in the manufacturing sector.

Weaker Cleansing Mechanism during the Pandemic

We examine the firm’s exit rate in terms of its overall financial healthiness. We use a variable called “score” with a value between 0 and 100, which is calculated by TSR based on financial health, management, and other firm-related information. A higher value implies that a firm is assessed to be financially healthier, from the perspective of a credit rating agency. Figure 1 shows the firm’s exit rate for all types of exits and bankruptcy rates for four bins categorized by a firm’s score, with Bin 1 containing firms with the lowest (below 25th percentile) score values and Bin 4 containing firms with the highest (above 75th percentile) score values. The left figure shows that the slope, which remained relatively stable before the pandemic, flattened in 2020, suggesting that the exits of weak firms during the pandemic declined compared to the pre-pandemic years. The right figure shows a general downward shift in bankruptcy rates over time, with a significant decline observed in 2020. In fact, even for firms in the first bin, bankruptcy rates remain below 0.2 percent, implying that bankruptcies were very uncommon in Japan during the pandemic.

Figure 1. Firm Exit Rate by Firm Score
Figure 1. Firm Exit Rate by Firm Score
[Click to enlarge]
Note: X-axis shows the quantiles of firms in each bin based on their score, with the weakest firms (below 25th percentile of firm score) in Bin 1 and the healthiest firms (above 75th percentile of firm score) in Bin 4. For the right figure, y-axis plots firm exit rates due to bankruptcy (Note 2) .

In addition to firm healthiness, we examine other firm characteristics known to be associated with firm exits, such as the size of firms (measured by the number of employees) and labor productivity. Before the pandemic, it was documented that smaller firms were more likely to exit, and less productive firms were more likely to exit in Japan (Hong et al. 2020). We find that these correlations weakened somewhat during the pandemic, with a lower rate of firm exits by smaller firms and less productive firms than before. However, there is one firm characteristic whose correlation with firm exits increased during the pandemic, and that is the age of owners. An important driver of firm exits in Japan, especially voluntary firm exits, is the age of the owner (Hong et al. 2020), as aging owners decide to close his/her business due to difficulties in finding a successor. We find that firms run by elderly owners continue exiting during the pandemic as before, while firm exit rate for young owners lowered compared to the pre-pandemic periods. To summarize, the low level of firm exits at the aggregate level appears different, depending on firm characteristics.

A rise in corporate indebtedness and zombie firms, but not in all sectors

Next, we examine the change in corporate indebtedness. At the aggregate level, the increase in long-term debt by corporations is more pronounced than the short-term debt (Figure 2), but an analysis using firm-level balance sheets is needed to understand the distribution of this corporate borrowing and its implications on corporate solvency.

Figure 2. Total Outstanding Debt: Long-Term Debt vs. Short-Term Debt from 2015Q1 to 2021Q2
Figure 2. Total Outstanding Debt: Long-Term Debt vs. Short-Term Debt from 2015Q1 to 2021Q2
Source: Financial Statements Statistics of Corporations by Industry, Ministry of Finance. Note: The dashed lines indicate a pre-pandemic trend line based on the period of 2015 to 2019 using linear interpolation.

To complement the aggregate findings, we examine the corporate indebtedness at the firm-level. Here, we adopt the definition of a “zombie firm” introduced by Fukuda and Nakamura (2011 and 2013, hereafter FN) to distinguish firms that face severe indebtedness from other, healthier firms (Note 3) .

Figure 3 shows the time series of the zombie ratio by industry (Note 4) from 2008 to 2020. The left chart depicts the time series of sectors with the largest increase in the zombie ratio in 2020 compared to the average of the previous three years. The right chart depicts the time series of sectors where the zombie ratio did not change significantly during the pandemic. We find that there is significant variation across sectors. The accommodation sector saw the greatest increase in the zombie ratio, with approximately 15 percent of firms identified as zombie firms in 2020. Interestingly, there is a significant increase in the zombie ratio in the manufacturing and finance sectors as well.

Figure 3. Zombie ratio (defined by FN) by industries (Note 5)
Figure 3. Zombie ratio (defined by FN) by industries
[Click to enlarge]
Source: TSR data

Conclusion with policy implications

Even though the aggregate bankruptcy rate remains very low, the COVID-19 pandemic appears to have deteriorated firm dynamism for Japanese firms. To support this argument, our first evidence is the weakened ‘cleansing mechanism’ with a reduction of firm exit rates even for less healthy firms. Secondly, the share of ‘zombie’ firms in certain sectors increased sharply in the past two years. Policy measures should strike a careful balance between providing support for firms against unforeseen shocks and facilitating exits of firms that are not viable. As past studies convincingly demonstrate, prolonging the lifeline of unviable firms will undermine the aggregate productivity and reallocations of labor and capital, dampening swift and robust economic recovery in the post-pandemic period.

(The views expressed here are those of the authors(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.)

  1. ^ As the lion’s share of firm exits in Japan is driven by voluntary exits rather than bankruptcies, as documented in Hong et al. (2020), the overall firm exit rate is driven by the results of voluntary exits.
  2. ^ The exit ratio for each year is defined by the number of exiting firms divided by the number of total firms. Since firm information is provided at the end of September each year and we use this to count the number of total firms, we define the number of exiting firms accordingly. For example, to calculate the exit ratio of the year 2020, we use the number of exiting firm from October 2020 to September 2021. The exit ratio of 2013-2015 is average of exit ratio for each year, that is, 2013, 2014 and 2015. On the other hand, balance sheet information is provided as a dataset sorted by the end of the fiscal year. As for the latest dataset for 2020, the fiscal year is from January 2020 to December 2020.
  3. ^ According to Fukuda and Nakamura (2011 and 2013), a zombie firm has to satisfy both profitability criterion and either subsidy criterion or ever-greening criterion. That said, among firms with profits that are unable to cover the minimum required interest payment, firms are defined to be zombie if their actual interest payments are less than the minimum required interest payments (subsidy criterion) or if their borrowings increase with debt over total asset ratios exceed 20 percent (ever-greening criterion). This measure differs from the widely-used definition that looks at the three consecutive years of interest coverage ratio below one. As the pandemic was an abrupt change in the economic environment, defining a zombie firm based on the three past consecutive years tends to misrepresent the zombie firms created in each year. In the case of Japan, where the ratio of zombie firms was trending down before the pandemic, the approach would generate in an underestimation of the zombie ratio.
  4. ^ We use large category of industry by Japanese Standard Industry Classification (JSIC) except for the sector of “wholesale and retail” to see the differences between them.
  5. ^ Zombie ratio is calculated following Fukuda and Nakamura (2011 and 2013), with a firm defined as a zombie if it satisfies the criteria below: \[EBIT_{i,t} \lt I_{i,t}^{*} \: and \: \bigl(I_{i,t} \: \lt \: I_{i,t}^{*} \: or \: (I_{i,t} \: \ge I_{i,t}^{*} \: and \: D_{i,t-1} \: \gt \: 0.2A_{i,t-1} \: and \: B_{i,t} \: \lt \: B_{i,t-1}) \bigl) \] Where \(I_{i,t}\) is interest payments; \(I_{i,t}^{*}\) is the minimum required interest payments \(I_{i,t}^{*} \: = \: r_{t-1}^{short} \: * \: B_{i,t-1}^{short} \: + \:(\frac{1}{5} \Sigma_{j=1}^{5} r_{t-j}^{long} ) \: * \: B_{i,t-1}^{long} \: + min⁡(r_{t-5}^{cb},…,r_{t-1}^{cb} ) \: * \: Bonds_{i,t-1}; r_{t-1}^{short} \) is the short-term interest rate (TBOR), \(B_{i,t}^{short}\) is the short-term borrowing from banks, \(r_{t}^{long}\) is the long-term prime rate (taken from Bank of Japan), \(B_{i,t}^{long}\) is the long-term borrowing from banks; \(r_{t}^{cb}\) observed coupon rate on any convertible corporate bond issued in year t; \(Bonds_{i,t}\) is total issued amount of corporate bonds; \(EBIT_{i,t}\) is earnings before interest taxes, taken the lower number of either operating income or pre-tax income plus interest payment; \(D_{i,t}\) is amount of outstanding debt and equals to the sum of \(B_{i,t}^{short}\), \(B_{i,t}^{long}\), and \(Bonds_{i,t}\); \(A_{i,t}\) is total assets; and \(B_{i,t}\) is borrowing from banks and equal to the sum of \(B_{i,t}^{short}\) and \(B_{i,t}^{long}\).
  • Fukuda, Shin-ichi, and Jun-ichi Nakamura. 2011. “Why Did ‘Zombie’ Firms Recover in Japan?” The World Economy 34(7): 1124–37.
  • Nakamura, Jun-Ichi and Shin-Ichi Fukuda. 2013. “What Happened To "Zombie" Firms In Japan?: Reexamination For The Lost Two Decades.” Global Journal of Economics, Vol. 2(2): 1-18.
  • Hong, G., A. Ito, Y. U. Saito and A.T.N. Nguyen. 2020. “Structural Changes in Japanese Firms: Business Dynamism in an Aging Society,” IMF Working Paper Series WP/20/182.
  • Hong, G., A. Ito, Y.U. Saito and A.T.N. Nguyen. 2022. “Did the COVID-19 Pandemic Create More Zombie Firms in Japan?” RIETI Discussion Paper, forthcoming.

April 5, 2022