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Industrial 'zombies' could threaten U.S. recovery

August 31, 2009 |  6:20 am

James Kelleher at Reuters points up a risk to economic recovery that hasn't been much discussed: the potential drag on the manufacturing sector from the financial toll the recession has taken on smaller companies in the supply chain.

From Kelleher:

Call them zombie suppliers. Analysts say the speed with which major manufacturers cut output in this recession put unprecedented strain on thousands of small manufacturers that supply the industry with critical parts.

That has left the supply chain with an unknown number of suppliers who are dead but do not know it --  companies so undercapitalized and overleveraged they will never raise the money they need to get their idle plants running again.

"Their lenders are going to say, 'Sorry, we're not going to increase our exposure with you because we don't know if you're going to make it or not,' " says Bill Diehl, the chief executive of BBK, an advisory firm that does supply chain risk analysis.

And that, of course, would be a horror show for the publicly traded manufacturers that rely on these suppliers. It could leave them scrambling to secure components once the recovery starts -- and missing some of the rebound's benefits.

This will be a big test of bankers' assertion that they're ready and willing to lend money again. Will they balk at extending new financing to many smaller manufacturers even if the companies can show rising orders? This may become a very big issue in greater Los Angeles, given the region's huge base of small and midsized manufacturers.

Japan had the opposite problem in its "lost decade" of the late 1990s and early 2000s: Its banks were under political pressure to keep alive zombie companies that no longer were viable.

As James Surowiecki at the New Yorker wrote in May, the popular recollection is that Japan's economy was held back by zombie banks that were propped up by the government but refused to lend. The reality, Surowiecki noted, was that many Japanese banks engaged in "evergreening" -- they kept pouring money into companies that already had loans with them, even if the companies' prospects were grim.

The practice "effectively meant that, instead of making good new loans, [the banks] were constantly throwing good money after bad. As a result, they were never able to earn their way back to health," Surowiecki wrote.

The challenge skittish U.S. bankers will face is in identifying which smaller manufacturers have a reasonable chance of bouncing back from the astounding collapse of industrial output that began last fall. The banks will face those decisions as companies ask for more credit to begin ramping up production -- which should happen soon in many industries that need to rebuild depleted inventories.

Kelleher quotes Craig Giffi, head of U.S. consumer and industrial products practice at accounting firm Deloitte:

"Until those companies have to produce something -- and to secure raw materials, to make a part, to hire more workers -- no one will know how weak their balance sheets and credit positions really are."

-- Tom Petruno