By He Fan Source: East Asia Forum Published: 2012-11-20
As Warren Buffett said, when the tide goes out, you can see who’s been swimming naked. As China’s growth slows, an army of zombie enterprises has emerged. These zombie companies are heavily indebted, kept afloat only by continuous support from government and banks. The government does not want to see zombie companies wiped out because it worries about the messy results—rampant unemployment and a significant loss of tax revenue. The banks are willing to lend a hand because they do not want to see their earnings fall when forced to make provisions to bad debts.
Both the government and the banks try to help these companies in the hope there will be a market rebound soon. Unfortunately, zombie enterprises are holding back economic recovery in China. Their existence prevents resources from being reallocated to more productive industries, resulting in an uneven playing field.
Senior leaders in China have pledged to phase out poor-performing zombie enterprises. Closing companies with overcapacity is a priority of the government’s ‘supply-side reform’ strategy. But what do zombie enterprises look like in China, and who are they?
Zombie enterprises are those that are losing money but can borrow at a price below the market rate. The more they lose, the more they can borrow—that’s the only way they can survive. Our research suggests that roughly 10 per cent of listed companies in China are among the walking dead. This is likely an underestimate, given requirements for listing.
Zombie enterprises are floating with the ups and downs of China’s growth. After the global financial crisis, the number of zombie enterprises increased sharply. But the RMB4 trillion (US$590 billion) stimulus policy the Chinese government adopted in late 2008 gave these enterprises breathing space. The number of zombie enterprises dropped briefly, and then rose again as China’s growth slowed. The zombie company problem has become much harder to ignore.
Zombie enterprises are clustered in industries burdened by debt and overcapacity, like iron, steel, aluminium and cement. These industries had investment booms that left behind too many factories and too little demand.
Although the real estate sector does not have the highest ratio of zombie enterprises, it makes up a large share of Chinese listed companies. Because so many apartments were built during the boom, developers have a difficult time reducing their inventory. State-owned enterprises (SOEs) have a higher propensity to turn into zombie enterprises—a private enterprise, after several years of losses, has no way to continue and has to shut down. SOEs, however, can keep getting fresh credit from the banks.
Drawing a line from China’s northeast to the southwest, one can find the new rust belt. Zombie industries are not located in the most advanced coastal areas nor the least developed Western backwaters, but in the middle—Heilongjiang and Liaoning in the northeast, Shanxi in the Loess Plateau, Hebei in the North China Plain and Hunan in the Yangtze Basin. They are either resource-rich or smokestack-heavy industrial bases. These less economically diverse areas are the most vulnerable to declining growth rates and commodity prices.
The greatest obstacle to shutting down or scaling back the zombie enterprises is unemployment pressure. Forcing zombie enterprises into bankruptcy will leave millions jobless. The government fears that mass layoffs could lead to social instability. The leadership has announced the establishment of a fund of RMB100 billion (approximately $US15 billion) to assist the newly jobless. But is it enough?
In six industries that have serious overcapacity problems: steel, coal, cement, glass, papermaking and non-ferrous metals, we calculate that if capacity needs to be downscaled by, say, 10 per cent, we calculate there would be around 4.31 million made redundant. The cost of helping the unemployed would be between RMB163.75 billion and RMB491.25 billion (US$24–73 billion), depending on how generous the government chose to be.
Since the global financial crisis, leverage ratios of other major economies have been reduced, while the leverage ratio in China increased sharply and is high compared with other economies.
The government is currently trying to combine deleveraging with overcapacity reductions. One new plan is to allow commercial banks to swap the debt they hold in underperforming companies for stock holdings. Whether this approach will help is open to debate.
The maximum amount of debt that one company can borrow should be no higher than its debt servicing obligations. If the aim of debt-for-equity swaps is to alleviate the debt problem for firms, then more attention needs to be paid to reducing the debt of companies so they can operate in safe territory. The industries that need the most help are steel and coal, where real debt is already RMB3.86 trillion (US$570 billion) higher than this maximum debt size.
According to one report, the profits of roughly a quarter of Chinese companies were too low in the first half of this year to cover their debt-servicing obligations. Earnings are languishing while loan burdens are increasing.
Companies may use debt-for-equity swaps to overcome temporary repayment issues, but the repayment issues will not easily disappear. Even worse, if banks cannot gain true ownership over indebted firms, the stress will be transferred from companies to banks.
The cost of closing or downsizing zombie enterprises may be higher than expected. Facing uncertainties, the government is still hesitating to swallow the bitter pill of factory closures and employee layoffs. Merging ailing companies will only create more giant zombies, and debt-equity swap may swap zombie enterprises to zombie banks. But there is no solution without pain and cost. Now is the time to take the right medicine and start feeling the pain before it becomes unbearable.
He Fan is Chief Economist at Chongyang Institute for Financial Studies, Renmin University of China.