Even as the European economy slumps into its deepest recession in modern history, the number of bankruptcies across the continent has fallen sharply as government subsidies and a temporary loosening of insolvency rules keep companies afloat.

During the first half of 2020, countries including Britain, France and Spain saw insolvencies fall by an estimated 20-40%year-on-year, official and private sector data show.

But as the region implements new restrictions to control a fresh rise in COVID-19 infections, the question for governments is whether to preserve jobs at the risk of creating a generation of debt-laden "zombie" firms with no real future.

For now, it seems a risk they believe worth taking.

In Germany, Europe's biggest economy, there was a 6.2% year-on-year drop in insolvency filings in the first half after the government temporarily waived a filing obligation. By contrast, U.S. Chapter 11 bankruptcy filings rose 26%, according to legal-services firm Epiq Systems Inc.

Now, Berlin plans to give troubled firms yet more leeway.

Local critics say the first-half fall in insolvencies is proof in itself the state has done more than enough and now risks impeding what economic liberals hail as "creative destruction", the term popularised in the 1940s by Austrian economist Joseph Schumpeter to describe unviable firms folding to make way for more dynamic newcomers.

But the issue is knowing how to distinguish the zombies - generally defined as companies which would anyway struggle to cover their interest payments - from basically healthy firms that have run into temporary trouble.

Jan-Marco Luczak, legal and consumer spokesman for Angela Merkel's conservative CDU/CSU, said it was "good and right" that the government helped businesses quickly and without red tape.

"But it is also clear that we must not permanently switch off the self-cleaning process of the market," he told Reuters. "Companies that are not healthy and have no economic prospects independently of corona must exit the market."

Germany's Federal Statistics Office confirms the drop in insolvencies was directly facilitated by government measures, including allowing firms to delay filing for bankruptcy until the end of September, now extended to the end of the year.

A new draft reform, which would take effect at the start of 2021, envisages extending the deadline for firms to file for insolvency to six from three weeks while also giving them the opportunity to terminate onerous contracts.

"The company is given a wide margin of manoeuvre in drawing up the restructuring plan, organising the negotiations and conducting the vote on the restructuring plan," the Justice Ministry said of the proposals in a written statement sent to Reuters.

That has raised alarm bells with the IDW Institute of Public Auditors, which is calling on the government to press struggling companies to restructure earlier, rather than when they face a real threat of insolvency.

STRUCTURAL CHANGE

Jens Weidmann, president of Germany's national central bank and a known fiscal hawk, also has concerns.

He acknowledges the "balancing act" involved in countering the pandemic's economic fallout with state support measures but, in a speech this month, highlighted the potential to kick-start what many would see as a long overdue structural change in Germany's economy away from its reliance on the industries of the last century. The auto sector is one such example.

"Digital transformation could get a real boost", he said, giving one example of the creative destruction that pro-market advocates are seeking.

Berenberg Bank economist Holger Schmieding said the government was not yet impeding corporate renewal, but was at risk of doing so.

"In this unusual and unusually deep recession, it makes sense to slow down the process of destruction."

"Over the course of next year, the balance will shift," he added. "Extending the moratorium on insolvency proceedings into next year would be wrong, in my view."

REDUCED PROSPECTS

Credit insurance and debt collection group Atradius estimates a 26% rise in insolvencies globally this year as governments start to phase out support schemes. However it predicts that any increase in the second half will be much lower in Europe than elsewhere.

The Paris-based Organisation for Economic Cooperation and Development (OECD) last week urged governments to review and refocus pandemic support measures as the recovery progresses.

Failure to do so could hinder the recovery by trapping resources in non-productive firms and jobs, reducing prospects for shifting jobs to more productive and higher-paid ones, it said.

In Spain, one of hardest hit European countries both economically and in health terms, some 130 leading economists are urging the government to fine-tune employment protection schemes to avoid non-viable companies being subsidised.

"It is key to avoid problems of incentives that could delay the revival of the economy and the reallocation of workers towards more productive enterprises," they wrote.

Britain is taking a different tack. While it has announced a wage subsidy scheme modelled loosely on Germany's long-running 'Kurzarbeit" short-time work programme, Finance Minister Rishi Sunak has made it clear the initiative - a much less costly replacement to furlough measures expiring next month - was not intended to save jobs that were not viable in the long term.-Reuters