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Zombie companies, which survive on borrowing as they do not have enough profits to cover debt-servicing costs, have grown in India amid easy monetary conditions and are sitting with nearly 10% of the nation's banking credit, according to a report by economists at the nation's central bank.

Such companies are generally highly leveraged and generate negative returns on assets over years. Their cost of funds is more sensitive to monetary policy shocks as they borrow more for survival rather than for new investment, according to a Feb. 16 paper by executives at the Department of Economic and Policy Research of the Reserve Bank of India, or RBI.

While there is no evidence that monetary policy easing during periods of economic downturn helps such companies by misallocating credit to them, "[zombie companies] seem to have dampened the effectiveness of monetary policy at the margin as they use borrowed resources more for their survival than for undertaking new investment," it said. The comments in the paper do not necessarily represent the views of the central bank, according to the report.

The debt share of zombie companies in India was the highest in at least 20 years in 2016, before dipping the following year. It ticked higher again in 2018 and has stabilized since then, according to the report.

Zombie companies tend to thwart the "creative destruction" process, which requires a dynamic reallocation of resources from weak and vulnerable firms to strong firms that have high growth potential. Coined by economist Joseph Schumpeter, "creative destruction" refers to the incessant product and process innovation mechanism by which new production units replace outdated ones.

The RBI, along with other major central banks, have pursued a policy of aggressive easing as the COVID-19 pandemic dragged on the global economy since 2020. The Indian central bank is now preparing to normalize its monetary policy, ending its bond-buying program, while still keeping benchmark rates low. The U.S. Federal Reserve is widely expected to start raising rates as early as March to curb inflationary pressures, while its Chinese counterpart has continued to ease, seeking to provide greater support to the economy's recovery. Easy monetary policy across the world has raised concerns of cheap credit flowing to unproductive uses.

Zombie companies in India operate with significantly higher leverage, measured by total debts to assets, though they managed to borrow funds at costs that were comparable to healthier firms, the report said. Despite their greater leverage, the share of zombie companies in total sales of the nonfinancial corporate sector has declined in recent years, it added.

India's banks have managed to slow credit flows to financially weaker companies, thanks to risk-based supervision and the insolvency and bankruptcy regime that may no longer support evergreening of zombie companies, the report noted.

"With further improvement in resource allocation through the banking system, however, there is scope for enhancing the effectiveness of countercyclical monetary policy," it added.