This article was first published in the April 2016 China edition of Accounting and Business magazine.

In their heyday, China’s behemoth state-owned enterprises (SOEs) were the nation’s lifeblood. Manufacturing for its own growth, and the world’s insatiable appetite for consumables, the steelworks and coal plants, aluminium smelters and cement factories were, in the words of ANZ chief economist Warren Hogan, ‘the real engine of Chinese growth’.

The whole social structure was built around them; as SOEs literally rebuilt a nation devastated by prolonged periods of war and underdevelopment, they provided not only employment for the masses but also a range of community services such as housing, education and healthcare.

Times change, and after nearly two decades of reform targeted to move China towards a modern enterprise system, those low-tech SOEs that didn’t survive the transition are still chugging along but in a counterproductive way. For the sectors they produced for are now in decline, and many of the industries which once accounted for around 48% of China’s GDP are not only loss-making but haemorrhaging badly. As their epithet implies, these so-called ‘zombie’ companies are like the walking dead, sucking the life out of an already spluttering economy.

The central government announced last December that slashing the number of inefficient and unprofitable zombie enterprises was a priority for 2016. In the firing line are companies that have been running at a loss for more than three years, and/or cannot meet the national standards for energy use, environmental protection, quality and safety. Their number has reportedly doubled from two years ago but as Paul Gillis, professor at Peking University, points out, ‘not much data on these companies is published.’ 

Agreeing that ‘it’s difficult to know precise numbers’, Li-Gang Liu, chief economist China at ANZ, says that, according to the bank’s analysis, 12% of China’s listed firms, and 14% of SOEs, ‘are loss making and may not be able to honour their interest payments’. The zombie firms are located mainly in overcapacity sectors such as steel, cement, construction glass and heavy equipment industry, he adds.

Deloitte research shows that China has around 150,000 SOEs, whose assets amount to RMB100 trillion, or 1.5 times the size of the national economy. These include 120 central SOEs ‘whose consolidations are subject to immense political constraints’, says Sitao Xu, chief economist at Deloitte China.

‘The state-owned sector accounts for 30 million people,’ Xu says. ‘According to official data, SOEs’ ROA [return on assets] is constantly lower than that of the private sector. Given leverage which is still rising – close to 70% – we should not underestimate the increasing risks to the financial system.’ The upside, he adds, is that China could use fiscal means to deal with potential job losses from SOE reform.  

Xu also points out that, while under-performing major enterprises are not unique to China – more than 10% of Korean companies, for example, are deemed by the Bank of Korea to be chronic zombie companies – the sheer weight of the debt accrued by China’s zombies, gorged to overcapacity by easy loans and government subsidies, may well be. According to estimates by Nomura, around 40% of all bank loans to Chinese companies go to SOEs, which only contribute to around 10% of the nation’s economic output.

Indeed, overcapacity in Chinese industry is described in a recent report by the European Union Chamber of Commerce in China as ‘a blight on China’s industrial landscape’, its influence on the economy, both domestic and global, becoming ‘ever more destructive’.

The report shows a worsening of overcapacity in eight key industries since the chamber published its first report on the topic in 2009, and points to the causes as ‘regional protectionism, weak regulatory enforcement, low resource pricing, misdirected investment, inadequate protection of intellectual property rights and an emphasis on market share’. 

Chamber president Jörg Wuttke was blunt. ‘China has not followed through on the attempts it has made over the last decade to address overcapacity. This has led to a further deterioration of the problem. Without a sustained effort to address it now, overcapacity may well seriously impede the effectiveness of China’s economic reform agenda.’

Xu notes that, ‘for market economies, companies do fail due to ‘invisible hands’’’ – a reference to the unobservable forces at play in business. However, no country has seen government subsidies of the scale found in China, nor the depth of its manufacturing overcapacity. With non-performing assets weighing on banks’ books, putting the Chinese economy at risk, shutting down zombie firms has become urgent, Xu says.

Liu agrees. ‘These loss-making SOEs could eventually default, leading to surging NPLs [non-performing loans],’ he says. ‘If there is no proactive policy to address them, banks will become very cautious in lending to everyone. This could lead to the closure of the credit channel, which in turn leads to more sluggish economic growth.’

The International Monetary Fund, which observed in a recent report that corporate debt in emerging market economies has risen significantly during the past decade, also remarked that, in China’s case, the high level of credit could weigh on the nation’s growth and financial stability. The central government has flagged that ‘some pain is inevitable’ for society in the latest round of SOE reform, but Liu does not think it will be as acute as when then-premier Zhu Rongji closed 60,000 SOEs in the late 1990s, leaving 40 million people unemployed. 

‘China’s private sectors are quite flexible and nimble,’ Liu says. ‘When they do not see profits in a particular sector, they will folder their investment and move on. However, SOEs are often supported by local governments with large social and economic stability implications, especially in some small towns where employment depends on one or two SOEs.’ 

Broadly speaking, Liu believes, this round of SOE closures will not need as much labour shedding. Given that China’s services industry is expanding rapidly and labour shortage continues in some segments of the economy, the challenges ‘will be much less difficult to manage’, he says.

Nonetheless, the government will still need to provide fiscal assistance to workers impacted, Liu says. ‘One favourable factor is that China’s central government does have a very good fiscal balance sheet, with a debt-to-GDP ratio at only 15%,’ he says. ‘The central government will have to shoulder most of the fiscal assistance programme.’

The key for the government in acting on its pledge to cull zombie companies is to ‘address them in an orderly way, so that such restructuring will not lead to social instability’, according to Liu. Meanwhile, China will need to encourage private and foreign participation in this process as well.

‘The loss-making SOEs’ restructuring must also involve private participation allowing mergers and acquisitions based on market principles, while the state could provide fiscal assistance to help retrain and resettle unemployed workers to maintain social stability,’ he explains. ‘In addition, local government should be encouraged to take initiatives and use innovative means to manage the restructuring process. At the same time, economic growth is still critical so that these restructured labourers will be able to find jobs without prolonged unemployment.’

Closing factories is never easy politically, Xu concurs. But there may be an upside. ‘In today’s China, the labour market is actually quite tight,’ he says. ‘A booming service industry is expected to absorb much of the job loss from industry consolidation.’

International accounting networks could make a positive contribution in the sense that the precondition for closing zombie companies is to recognise losses and provide market-to-market valuation, Xu adds. ‘Indeed, Deloitte is well positioned for helping firms shed non-performing assets and in turn improving the competitiveness of the sector.’

Peta Tomlinson, journalist