Uncertainty Creates Zombie Firms: Implications for Industry Dynamics and Creative Destruction

Abstract
We show how the threat of “uncertainty-induced zombification” — creditors’ willingness to keep their distressed borrowers alive when faced with uncertainty — shapes various industry  dynamics. Under a real options framework, we demonstrate that unlevered firms become reluctant to invest and disinvest in anticipation that uncertainty induces creditors to convert defaulting rival firms into zombies. We validate our theory using dynamic, industry-specific estimates of uncertainty-induced zombification together with loan contract-level data. Empirically, higher uncertainty-led rival zombification prompts healthy firms to reduce their costly-to-reverse capital investment and disinvestment, hiring, and establishment-level openings and closures (intensive and extensive margins are affected). We confirm those dynamics using granular, near-universal data on the asset allocation decisions of global shipping firms. Critically, uncertainty-led zombification depresses healthy firms’ long-run sales, profits, and stock returns. Our results reveal nuanced effects on creative destruction — while healthy firms’ asset reallocation slows down, their innovation activity accelerates. Our findings highlight a novel channel through which uncertainty shapes firms’ capital accumulation,  distorting their real and financial policies and performance.