Germany faces zombie firm dilemma

To rescue or to let die — that was the question in March in Europe's economic powerhouse, Germany. The government opted for a rescue plan.

In theory, companies that default on their obligations and have piled up huge debts have to file for insolvency. But as of March 1, they have no longer had to — thanks to a new law that gives them more breathing space. The legislation in question will be in place at least until the end of September.

It's a period of grace that many companies need badly in order to come to terms with the fallout of the coronavirus pandemic. A brief look at Germany's gross domestic product (GDP) highlights the dilemma at hand: Even in the first quarter of the current year, the economy contracted by 2%, followed by a 10% nosedive in the second quarter. Analysts expect GDP to tank between 5% and 8% in 2020 as a whole.

Aid packages worth billions of euros have been adopted to assist struggling firms in Germany and the whole of the European Union. For instance, the government in Berlin boosted its support for short-time work schemes, reduced VAT, allowed for tax breaks and in some cases even bought into ailing companies. The question is whether all these efforts will really help beleaguered firms survive at the end of the day.

Many fear that Germany may see a huge wave of bankruptcies starting in October, when companies in deep trouble will have to file for insolvency again.

Is jumping on the bandwagon a good idea?

So far, the number of insolvencies has decreased. "In the first six months of the year, insolvencies dipped by 8% year on year," Patrik-Ludwig Hantzsch, from the credit agency Creditreform, told DW. The German statistics office Destatis expects the July figure to decrease by 30%.

Even though this can be seen as a success story, the figures provide indications that among the companies profiting from the new legislation there are firms who were already in trouble before the onset of the pandemic. This is because all companies experiencing cash flow problems and high debt levels as early as December 31, 2019, didn't have to file for insolvency. At that time, there was no talk yet of any pandemic in Germany, and some simply jumped on the bandwagon to profit from the legislation in question.

Healthy companies and zombie firms

Hantzsch said it was crucial in the beginning to give companies some leeway to make sure that state aid programs had the desired effect. Nevertheless, he added, it would be important to allow for a market adjustment via insolvencies even during a crisis.

"If no firm leaves the market, it basically means that you stop differentiating between good and poor business models," Hantzsch argued, saying that such a development could also impact healthy companies.

When the economy recovers, firms have to remain cautious, "because they have no way of knowing who's bust and unable to pay and who will pay the bills no matter what," Hantzsch explained. This can harm sound companies if their bills are not paid, potentially leading to knock-on insolvencies.

According to Deutsche Bank Research, such "zombie firms" tend to pursue an aggressive price policy, which in turn impacts the profits of healthy companies and hobbles structural change.

"Let's not forget, transformation processes were in full swing in many sectors, including the auto industry, even before the coronavirus crisis," Hantzsch said, adding that the pandemic was "acting as a catalyst" that's now out of operation due to the temporary changes to Germany's insolvency regulations.

But Klaus-Heiner Röhl from the German Economic Institute (IW) is concerned with what happens when the legislation expires. Should there really be a wave of insolvencies, then this would also weigh on the labor market and lenders, he told DW. "The lenders act as creditors for these insolvent companies, meaning there's the threat of a renewed banking crisis," Röhl said.

Seismograph not working

So, how are firms in Germany really doing? Normally, says, Hantzsch, insolvencies act as a kind of seismograph to analyze the current state of the economy. But since this instrument is not available right now, Creditreform is resorting to other indicators.

"We had a look at companies' payment performance, incoming orders and other aspects and came to the conclusion that firms are hurting," Hantzsch pointed out. He said many companies are running out of money; there are more and more delays in the payment of outstanding bills. Payment performance, says Hantzsch, has not been poorer since the summer of 2015 when Creditreform first analyzed this particular benchmark.

According to a June 2020 poll by the Munich-based ifo economic research institute, one-fifth of all German firms feared they might not survive the pandemic. For its part, Creditreform estimates that some 550,000 companies will be in deep trouble by September. That would be about 220,000 zombie firms more than back in 2018.

Kicking the can down the road

If the coronavirus crisis lingers on and if the current insolvency regulations remain in place beyond September, the number of struggling companies will rise further, says Hantzsch. German Justice Minister Christine Lambrecht has already indicated she wants to keep these regulations until March 2021.

But many companies are not so sure. The president of the Association of German Chambers of Industry and Commerce (DIHK), Eric Schweitzer, believes that delaying a return to the pre-coronavirus insolvency legislation would harm creditors and put even more companies at risk. Germany's Registered Association of Insolvency Administrators doesn't think much of a further delay either.

In order to reduce the number of expected insolvencies and curb rising corporate indebtedness, Röhl says emergency loans should no longer be granted. "This is because credits will have to be paid back at some stage," he reasoned. Instead, he suggests transforming some of those already granted loans into aid money meant for instance to safeguard jobs and apprentice positions.