Non-performing "zombie" firms and debt-ridden state-owned enterprises (SOEs) are an increasing drag on China’s overall economy, and fixing them, through deleveraging, reducing government subsidies, as well as operational restructuring could enhance long-term economic growth by 0.7 to 1.2 percentage points per year, according to a new report by the International Monetary Fund.
China’s nonfinancial private sector debt has increased significantly over the past decade, reaching 176% of GDP as of the end of March 2017. Corporate debt, standing at about 135% of GDP, contributed most of the rising debt and has become a key vulnerability in China’s economic stability. SOEs accounted for 57% of total corporate debt, or 72% of GDP in 2016.
Zombie firms, defined by the Chinese State Council as firms that incur three years of losses, cannot meet environmental and technological standards, do not align with national industrial policies, and rely heavily on government or bank support to survive.
The paper shows strong linkages between zombie firms and SOEs in contributing to corporate debt vulnerabilities and low productivity. For example, nearly half of zombie firms’ debt is related to SOEs. At the same time, zombie firms that are also SOEs remain zombies for a longer period and are less likely to become viable again, according to the IMF.
Share of nonviable zombie firms in total corporate debt also rose quickly to 6% by the end of 2016 (or 15 % of total industrial liabilities), the highest level since 2009. The debt share of zombie firms has remained high despite declining employment, profitability, and fixed asset investment, suggesting rising vulnerability due to a debt overhang.
Studies find that zombie firms tend to crowd out private investment, contribute to lower productivity growth, and hinder competition. For example, zombie firms tend to crowd out non-zombie firms’ investment by 2% to 8%. As a result, they may drag overall productivity and growth and pose financial stability risks by adding to nonperforming loans in the financial system.
The paper shows that efforts to resolve these firms should focus on government-led process that allows market forces to operate, while complementary actions should follow with operational restructuring to raise efficiency. Suggested measures include banks initiating a targeted asset quality review to assess firm viability, developing operational restructuring plans, such as merge them with sound SOEs or encourage creditors to refinance, and hardening budget constraints for zombies and SOEs in general.