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China and Its Zombies: Traps of State-Owned Enterprises

Nov 27, 2020

From an impoverished, stagnant, and centrally controlled economy, China’s rise has been nothing short of spectacular. For decades China was one of the world’s fastest growing economies, effectively doubling its GDP every eight years and raising nearly 800 million Chinese out of poverty. However, as its economy matured, China’s economic performance began to decelerate, prompting Chinese leadership to devise new growth models. As President Xi Jinping indicated at the 19th National Congress of the Communist Party of China, “This is a pivotal stage for transforming our growth model, improving our economic structure, and fostering new drivers of growth.” 

Indeed, China is currently at a critical juncture. There are growing concerns that the “middle-income trap” looms large on China’s horizon. The middle-income trap is a narrative of growth stagnation. According to this assumption, middle-income states have to find new drivers of productivity, which are no longer tied to cheap labor, basic technology imitation, and reallocation of capital from low-productivity to high-productivity sectors. Otherwise, such states run the risk of being squeezed by both lower-wage and higher-tech states, becoming trapped at middle-income levels and failing to demonstrate previous levels of growth. That said, while newer empirical evidence challenges the very existence of a trap altogether, the middle-income trap is a very powerful idea that urges policymakers to pursue policy choices relevant to specific stages of a country’s development. The findings of a “trap” indicate that states in middle-income transitions may experience slow growth and even growth reversals unless certain policies are introduced to strengthen economic fundamentals. 

One of such propositions is to promote efficient resource allocation, which may be particularly relevant to modern China that has been experiencing the problems of poorly oriented investments and capital misallocations in certain industries. As China began to catch up with major developed states, its levels of productivity gains began to slow. There is evidence that Beijing’s support of state-owned enterprises (SOEs) is one of the main factors that lead to chronic resource misallocation, and thus preventing China from reaching high-income levels. As the artifacts of a centrally planned economy, SOEs show to constantly struggle to transform into effective profit-making machines. 

In political economy, “zombie companies” is the term used to label companies that depend on bailouts, and Chinese SOEs are one of the most extreme versions of “zombie enterprises”. For instance, according to the Ministry of Finance of China, the number of loss-making SOEs steadily grew from 41,200 in 2010 to 76,100 in 2018. Corporate debt also surged, with SOEs accounting for nearly 82% of that debt. However, instead of letting underperforming SOEs go bankrupt, the Chinese government consistently bailed them out and kept them afloat. The SOEs’ share of corporate debt is indicative of their privileged access to credit lines with more lenient requirements, and less screening. 

Even though supporting such companies can weaken the role of the market, reverses market competition, discourages innovation, and decreases productivity, the Chinese government has long treated SOEs preferentially. It is not only the pain of layoffs that motivates the Chinese government to extend the life of those companies. Chinese SOEs themselves grew powerful enough to influence public policy choices. Furthermore, SOEs are a vivid example of the convergence of interests of local governments, vendors, and financial institutions who are all interested in sustaining the status quo at the expense of a public good. 

That said, it seems that Chinese leadership fully understands the challenge of finding new sources of growth in order for China to pass the high-income threshold. As Xi Jinping stated, “It is imperative that we develop a modernized economy. We need to raise total factor productivity and accelerate the building of an industrial system that promotes coordinated development of the real economy with technological innovation, modern finance, and human resources.” Total factor productivity (TFP) that Xi Jinping refers to in essence is a proxy for the efficient allocation of resources. Macroeconomists often use TFP to assess whether the economic growth of a particular state is driven by the efficient use of capital, liberalization policies, and technological progress. For instance, the IMF estimated that China’s TFP averaged only 2.25%a year since 2008. 

Accordingly, China launched a deleveraging campaign in 2016 to reform its economy and fight “zombie enterprises”. By 2018 there were 98 functioning specialized bankruptcy courts, while the number of the enterprise insolvency cases that were adjudicated increased from 2,352 in 2015 to 11,669 in 2018. These numbers are still relatively modest for China, as they include companies with all forms of ownership. Furthermore, the decrease in the number of “zombie SOEs” was administered mainly through mergers and acquisitions, which led to fewer but larger SOEs. 

The much-acclaimed Belt and Road Initiative can be also viewed to some extent through the prism of China’s attempt to address its “zombie” problem. Instead of defaulting on the debt-laden SOEs, Beijing decided to extend their lives by engaging them in large infrastructure projects beyond China. Since most Chinese “zombie companies” are clustered in such industries as steel, coal, cement, and non-ferrous metals, BRI projects can be simply viewed as an international secondment of “zombie SOEs”. However, such life support of old-fashioned industries is unlikely to mitigate China’s problems of poorly oriented investments and capital misallocations. 

Moreover, both the China-U.S. trade war and the COVID-19 pandemic have already significantly derailed the five-year deleveraging plan put forward by the Chinese leadership in 2016. Accordingly, the Chinese leadership would have to postpone its reformist plans and instead focus on plugging financial shortfalls, which in essence means stimulating the economy with more debt, including more bailouts and concessions to unprofitable and indebted SOEs.

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