"Zombie firms" are coming, and these walking dead could threaten to undo the post-pandemic economic recovery as long as government intervention masks a coming corporate solvency crisis.

"Fears are mounting that overburdening of the corporate sector with debt in the response to COVID-19 could create a new wave of zombie firms, with harmful consequences for the prospects of economic recovery," said a Dec. 14 report from the Group of 30, an international economic and monetary affairs consultancy. "As interest rates stay low and governments continue to support struggling firms, the risk of zombie firms increases."

Liquidity support from governments is "masking an underlying reality that is way more worrisome," a corporate solvency crisis with firms unable to pay their long-term debts, said Mario Draghi, the former president of the European Central Bank and a Group of 30 senior member.

Zombie firms are companies that cannot cover debt servicing costs from current profits and are dependent on creditors to stay open. The term was born following the collapse of Japan's asset price bubble in 2001 as Japanese banks lent to insolvent borrowers to avoid balance sheet losses and the backlash from denying needy companies credit.

Hotel chains, airlines and other "high contact" companies in the services sector are particularly susceptible to becoming zombies in the near term, said Raghuram Rajan, a Chicago Booth School of Business professor and another Group of 30 member.

Insolvency 'cliff edge'

Many of these service sector companies could be over-indebted and unless they get their capital structures back in order, the distress could bleed throughout the entire economy, Rajan said in a news briefing with Draghi on Dec. 11.

"The problem is worse than it appears on the surface, as massive liquidity support, and the confusion caused by the unprecedented nature of this crisis, are masking the full extent of the problem, with a 'cliff edge' of insolvencies coming in many sectors and jurisdictions as support programs lose funding and existing net worth is eaten up by losses," the report states.

Government actions in response to the pandemic have consequences that have yet to be fully seen, and the full extent of corporate distress may not be known for years, Rajan said.

"We are not yet out of the pandemic, but we should start preparing for what's next," he said.

'Winners and losers'

The report includes a number of policy recommendations, largely focused on moving away from broad measures to targeted efforts for specific firms and sectors. These efforts should recognize "winners and losers," the group said, and stop support of heavily indebted companies unlikely to survive in a post-COVID economy.

"Not all struggling firms should receive public support," the report states. "Resources should not be wasted on companies that are ultimately doomed to failure or which do not need public support."

The report recommends that governments turn to the private sector to lead efforts to select where measures should be targeted and for financing balance sheet restructurings.

"Banks and private sector investors usually have substantially more expertise in evaluating viability, and they certainly face less political pressure as they make those decisions," the report states.

Janet Yellen, the former Federal Reserve chair who is President-elect Joe Biden's pick to be Treasury secretary, is also a Group of 30 senior member.