The European Bank for Reconstruction and Development (EBRD) warns of the dangers of permanent over-indebtedness of companies and "zombification of the corporate sector".

Although this is not "yet" the case, there is a risk if companies that are essentially not viable are dragged on by issuing more and more loans - to the detriment of the economy and its competitors, who have to face unfair competition on the market and have poorer access to get capital.

Andreas Mihm

Business correspondent for Austria, Central and Eastern Europe and Turkey based in Vienna.

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After the pandemic led to ever higher corporate debt, it is now time for the states to reduce their credit lines and for the banks to take more precautions, writes the Eastern European Bank EBRD in a new report on the status of the economic alignment of the states it serves.

These are mainly in Eastern Europe, the former Soviet Union and Turkey.

In particular, the rapidly rising interest rates fueled doubts as to whether companies would be able to bear the sharp increase in credit burdens in the future - with possibly far-reaching consequences for banks and national economies.

Austrian National Bank nervous

This concern is also driving the Austrian National Bank (OeNB), which, among other things, oversees the Austrian banks that are heavily involved in Eastern Europe, such as Erste Group and Raiffeisen Bank International (RBI).

The banking sector has a “solid risk-bearing capacity”.

However, the negative effects of inflation and the ongoing geopolitical tensions led to growing stability risks on the financial markets.

Therefore, the banks should use their good earnings situation to further strengthen the capital base and secure their "outstanding" ratings, demands OeNB Deputy Governor Gottfried Haber.

The planned increase in the macroprudential capital buffer will further strengthen the resilience and reputation of the Austrian banking sector.

One reason for the requirements for more precautions is likely to be RBI's large commitment in Russia.

The bank is one of the few Western credit institutions still active in Russia, thus also facilitating payment flows for transactions not sanctioned by the West.

RBI considering going out of business.

However, it is unclear how and under what conditions this can be achieved.

EBRD ensures credit growth

In its analysis, the EBRD focuses on the strong credit growth of companies in their region.

Driven by cheap government loans, lending would have exceeded the previous high of 2016.

In 2021 they would have exceeded 150 percent of gross domestic product for the first time.

From 2009 to 2020, the average interest rate fell from 10 to 4 percent, with companies that have been struggling for a long time often being able to borrow at even more favorable rates - these are often state-owned companies or those that are kept afloat by state banks.

A sector analysis shows that these are often companies from the oil, gas, coal or water sectors that are politically controlled.

However, the lifting of moratoriums on foreclosure and insolvency of state-owned companies and the scheduled closure of insolvent state-owned companies are essential, not least in order to improve the management of these companies in the long term according to recognized standards.

zombification feared

Even if it was right to protect companies in the exceptional circumstances of the pandemic, "the continued extension of credit for non-viable companies leads to their zombification," warns the EBRD in its analysis.

This hinders the process of creative destruction, which is an essential element of a healthy and dynamic economy.

The Organization for Development and Cooperation (OECD) defines "zombie companies" as those that have been in existence for more than ten years and have not been able to cover their interest burden from operating profit for three consecutive years.

Almost a quarter of the companies examined are considered to be financially ailing - every fifth of them, i.e. 5 percent of all companies, must be classified as "zombie companies".

Among state-owned companies, however, the rate is much higher, at 13 percent.

The development bank, which was founded after the fall of the Iron Curtain and promotes only the private sector, advises that governments should gradually reduce financial aid for companies, strengthen bank supervision, reform bankruptcy procedures and develop private debt and stock markets.

Bankruptcy law reform and efficient restructuring alone were not enough to prevent lending to zombie firms.

For example, the new insolvency law introduced in India in 2016 had little impact on lending to such companies, as the predominantly state-owned and poorly capitalized banks continued to lend.

Poorly capitalized banks would therefore continue to lend to “zombie companies” and in this way prolong their status because they could find themselves in trouble if the debtor went bankrupt.

The cuts in state loan guarantees and subsidies must be phased in, with the reductions ideally concentrating on structurally weak companies.

Governments, if any, should only financially cushion solvent and viable companies with temporary liquidity problems.

The EBRD advises banks to adequately assess their borrowers and "provision appropriately for losses".