China's "zombies" are non-viable firms that are adding to the country's rising corporate debt problem and are bad business. Zombie firms are highly indebted and incur persistent losses but continue to operate with the support of local governments or soft loans by banks - adding very little value to economic prospects. China has already made a lot of progress in resolving these firms and should continue its efforts to send the zombies packing.
Despite persistent losses (over three years), lower returns, and inefficient operations, many of these zombie firms still manage to stay alive - about 30 percent of them remain zombies after five years.
Our chart of the week from a recent IMF working paper shows that finding a way to resolve the problems of weak firms in China can generate significant gains of about 0.9 percentage points in long-term growth per year. This can be done by phasing out the implicit support and making better use of resources that are currently going to zombie firms, overcapacity industries, and state-owned enterprises, and putting them towards more dynamic and profitable ventures.
How zombies survive
Generally, most nonviable businesses are forced to shut down because they fall prey to market forces and are unable to meet their bottom line. But zombie companies are able to survive because they typically receive implicit support on credit from banks and local governments - in the form of soft loans or implicit guarantees - with estimated interest payment costs below market lending rates.
This support along with the government's desire to boost growth has encouraged zombie firms to invest excessively - which raises already high leverage and weakens their ability to service debt - in the hopes of resurrecting profits and stabilizing the economy.
Cleaning up zombies
China's zombie firms also overlap considerably with the state-owned enterprises. Together, this group accounts for a large share of corporate debt (about 6-11 percent of GDP) and contributes to much of the rise in debt-posing risks to financial stability. Studies also show that zombies hinder competition and tend to crowd out more profitable, non-zombie firms' investment by 2-8 percent.
With such firms on the rise again - the share of zombies in total corporate debt rose quickly by 4 percentage points of GDP during 2008-16, the highest level since 2009 - there remain huge causes for concern.
As a result, resolving state-owned enterprises and non-viable zombie firms have become a key priority for the Chinese government to contain the risks associated with ballooning corporate debt and to help improve resource allocation among firms. And China is making progress in this area: reportedly, the government resolved about 20 percent of the identified central state-owned enterprises that were zombies last year by merging, divesting non-core business, and liquidation. Moreover, the government recently merged a few of large state-owned enterprises in the power, steel, and shipping sectors.
Reforms are key
Reforms on corporate governance (such as divestment and a change of management) and deleveraging by writing off nonperforming debt and operationally restructuring the firms can help liquidate these unprofitable firms and foster competition. Tighter budgets for zombies and state-owned enterprises - by suspending implicit support on credit access and allowing greater corporate defaults - can also help to clean up these weak firms.
Furthermore, our research shows that reforming state-owned enterprises, including by hardening their budget constraints, and opening up state-dominated services sector can lead to gains in output by almost half a percentage point in the long term.
With the right strategies in place, the government can help to boost productivity and long-term growth and finally put the zombies to much needed rest.