Labor Productivity Eroded by Zombie Companies (Comprehensive)

Bank of Korea BOK Issue Note
Zombie Firms' Labor Productivity Less Than Half of Normal Firms
Manufacturing Productivity Could Increase by 1% if Resolved
Careful Restructuring Needed by Industry and Cause of Emergence

[Asia Economy Reporter Kim Eunbyeol] Chronic marginal firms (zombie firms) that have not been restructured in a timely manner were cited as a factor lowering South Korea's labor productivity. Marginal firms refer to companies that cannot even cover their financial costs (interest) with their operating profits. Since these companies continue to stay in the market, blocking the entry of new firms and causing inefficient allocation of resources, precise restructuring is necessary.

Song Sangyun, Senior Research Fellow at the Bank of Korea Economic Research Institute, stated in the report "BOK Issue Note - The Impact of Marginal Firms on Labor Productivity in South Korea's Manufacturing Industry," released on the 20th, "Assuming the proportion of chronic marginal firms did not increase from 2010 to 2018, the normal firms' fixed asset growth rate, employment growth rate, and labor productivity increased by an average of 0.5 percentage points, 0.42 percentage points, and 1.01 percentage points per year, respectively."

Marginal firms generally refer to companies with an interest coverage ratio below 1 for more than three consecutive years. The interest coverage ratio is the operating profit divided by interest expenses, and a ratio below 1 means the company cannot even cover its interest expenses with operating profit. This term originated after Japan's asset bubble burst in the 1990s, referring to companies kept alive by banks.

Recently, with the continuation of a low-interest-rate environment and comprehensive support for companies worldwide due to the COVID-19 pandemic, the issue of restructuring marginal firms has come to the forefront as the crisis prolonged. Last month, Bloomberg reported that "if zombie firms are not restructured, there will be consequences," emphasizing the need for plans on how to handle these firms once the U.S. Federal Reserve's support ends.

According to the report, the proportion of marginal firms in South Korea's manufacturing sector increased from 7.4% in 2010 to 9.5% in 2018, a rise of 2.1 percentage points. The proportion of chronic marginal firms rose from 4.2% to 5.8%, an increase of 1.6 percentage points, while new marginal firms only increased by 0.5 percentage points to 3.7%. The quality of marginal firms was also poor. The interest coverage ratio of marginal firms, which was around -1.03 in 2010, dropped to -2.4 in 2018. This indicates the emergence of low-profit marginal firms and insufficient exit of existing marginal firms.

Therefore, the labor productivity of marginal firms was only 48% compared to normal firms, less than half. Among them, the labor productivity of chronic marginal firms and low-profit, high-debt marginal firms was 47.7% and 41.3% of normal firms, respectively. By company size, the labor productivity of small-scale chronic marginal firms was as low as 44.2% of normal firms. By industry, the proportion of marginal firms surged recently (2016?2018) in other transportation equipment (17.6%), textile products excluding clothing (14.8%), electronic components (13.4%), and pulp (12.9%).

Senior Research Fellow Song said, "If restructuring of marginal firms is carried out, labor productivity can improve significantly," adding, "Since labor productivity and recovery rates may vary depending on duration and causes of appearance, prescriptions should differ according to characteristics." He also added, "The accumulation of marginal firms may be due to loose lending practices by financial companies, government policy financing, and difficulties in business closure due to excessive costs, so it is necessary to carefully examine why marginal firms have not been exited from the market."

Professor Shin Sedon of Sookmyung Women's University Department of Economics cited three main reasons for the collapse of manufacturing competitiveness and firms becoming 'zombies,' arguing that the government should evaluate the situation and open a path for firms to survive. He said, "In industries like foundry and mold manufacturing, where facilities and technology are very outdated, the root industries cannot be killed just because they are marginal firms. Such industries should be modernized and competitiveness should be revived through education enabling operation of the latest equipment."

He also emphasized, "For places losing price competitiveness due to imports from China and Vietnam, directions should be set for them to switch industries, and for firms that are too small and vulnerable, mergers and acquisitions (M&A) to increase scale competitiveness is also a method." The Bank of Korea's study used data from 76,753 manufacturing firms included in the Corporate Activity Survey from 2010 to 2018.

This content was produced with the assistance of AI translation services.