One of the more interesting developments in official Chinese discussions about the economy has been the appearance of the term “zombie companies”; Premier Li Keqiang himself has repeatedly used the term. It’s a loose shorthand for a problem that everyone knows about but is difficult to precisely define: money-losing companies that seem to stay alive far longer than economic fundamentals warrant. This problem is particularly acute in the commodity sectors: a global supply glut has driven down prices of iron ore and coal to multi-year lows, levels where China’s relatively low-quality and high-cost mines have difficulty being competitive. And yet they continue operating despite losing money, because it is easier to keep producing than to completely shut down. An excellent story this week in the China Economic Times on the woes of the coal heartland of Shanxi quoted one executive saying, “If we produce a ton of coal, we lose a hundred yuan. If we don’t produce, we lose even more.”
The incentive problem is very clear. If many companies shut down, output would fall and prices would rise, and the remaining companies would be more profitable. However every company wants to be one of the companies that is left standing rather than one of the companies that shuts down, and so they do everything they can to continue operating. They can also usually count on help from banks and local governments, who want to avoid the financial and social impact of a large employer closing. This is why there are increasing calls for the central government to break the logjam and organize the closure of excess capacity that market mechanisms should be producing. Indeed, I translated on this blog a very interesting proposal from the State Council’s Development Research Center on how to do exactly that.
The fact that top leaders are now talking openly about zombie companies could indicate some progress on this issue. So here’s another relevant translation: a recent interview with Feng Fei, a senior industrial official. Feng is also one of China’s top scholars of industrial policy, and in fact spent many years at the DRC. In October he was elevated to one of the vice-minister jobs at the Ministry of Industry and Information Technology, which has bureaucratic responsibility for most of the sectors with lots of zombie companies. His interview with Caijing magazine is short but to the point. He diagnoses the problem and its consequences very clearly, but hedges a bit when asked what the government is going to do. However he seems to indicate that the current preference is to deal with zombie companies by encouraging stronger companies to take them over–which I think is not as good a solution as the one the DRC has already proposed.
Reporter: Why is the exit of “zombie companies” being discussed now? What is the background to this question?
Feng Fei: There is not yet a consensus view about “zombie companies.” My understanding is that “zombie companies” refer to companies that have been losing money for a long time, and which have no hope of turning around or smoothly exiting the market. Currently the problem of “zombie companies” is very prominent, and this is related to three major issues in the economy.
First, China’s economic growth has entered a “new normal.” Downward pressure on the economy has increased, and the external environment for business is getting tougher. There are some companies whose technology, management and so forth are relatively poor, and who are finding it difficult to adapt to the new situation and to market changes, and as a result have fallen into serious trouble.
Second, there is serious excess capacity in some industries, resulting in a continuous decline in product prices and a fall in corporate profits. There are some sectors in which all companies are losing money, and operations are very difficult. For instance, in the third quarter of this year, the steel industry’s profit margin on sales was only 0.05%, and the sector’s total profits declined 97.5%; nearly half of the companies in the sector are loss-making.
Third, the market system is not robust: there are still some institutional obstacles that result in “zombie companies” finding it difficult to exit according to market rules.
Reporter: In more specific terms, what harm do “zombie companies” bring to China’s economy?
Feng Fei: The existence of a large number of “zombie companies” hinders China’s economic transformation and the upgrading of its industrial structure, and also increases macroeconomic risks.
First, these companies are holding on to a lot of resources, hindering the effective resolution of excess capacity. “Zombie companies” have low profitability, but take up a lot of land, capital, energy, labor and other resources, and prevent these resources from flowing to more profitable sectors, resulting in a serious waste of resources. You could even say that if “zombie companies” do not exit the market, the problem of excess capacity cannot be fundamentally solved, and it will be very difficult to achieve structural adjustment and industrial upgrading. Only if enough companies exit will there be enough companies entering.
Second, it undermines the market principle of survival of the fittest. Because of social stability considerations and other issues, there are efforts to preserve “zombie companies” and give them blood transfusions. This results in unfair competition, and could even cause a Gresham’s Law phenomenon [in which the bad drives out the good].
Third, it may lead to financial risks. “Zombie companies” have a lot of debt, which if not dealt with in a timely manner will result in an increase in banks’ non-performing loans. When you add in the complex chain of inter-enterprise debt, the problem becomes serious, and could lead to systemic risk. Therefore the State Council is paying great attention to this issue, and has required [us] to handle the “zombie companies” issue.
Reporter: If it is so urgent for “zombie companies” to exit the market, why has this been a difficult issue for so long? Why is it hard to establish a mechanism for market exit?
Feng Fei: “Zombie companies” can be dealt with in two ways, through market-oriented mergers and restructuring, or bankruptcy according to law. The handling of “zombie companies” will be more through restructuring, and less through bankruptcy, and will also ensure social stability. In terms of these methods, China has considered the design of the system, but has faced some difficulties and problems in terms of actual operation, and a complete system for market exit has not yet been formed.
First, in the restructuring and bankruptcy processes, there are difficulties with the placement of workers, the debt burden, and historical issues, which increase the cost of restructurings and bankruptcies. This is an obstacle to “zombie companies” exiting the market.
Second, some local governments interfere in the normal process of bankruptcy and market exit because of considerations related to preserving jobs, maintaining social stability, or the worries of banks and other creditors about bad debts.
Third, China’s “Bankruptcy Law” needs to be further clarified and refined. Although it has already been revised several times to adapt to the market economy, there are still some regulations that are more like general principles.
Fourth, in the context of increasing downward pressure on the economy, many sectors do not have a clear outlook, and firms face financing difficulties, which means they have little interest in pursuing mergers and corporate restructuring.
Finally, the current economic situation increases the risk and the consequences of corporate bankruptcies, which means that many parts of society are very wary toward bankruptcies and restructuring.
Reporter: According to the State Council, the Ministry of Industry and Information Technology is in charge of researching and promulgating policies on “zombie companies.” What is your plan for this work?
Feng Fei: MIIT will step up its research and survey work, find out the true situation, and figure out the major difficulties and problems in “zombie companies” exiting the market. In conjunction with relevant departments, we will research policy measures to handle “zombie companies,” improve the market, legal and policy environment, and improve the exit mechanisms for “zombie companies.”
The exit of “zombie companies” requires a proper relationship between the government and the market. The role of government is mainly to provide the necessary support for displaced workers, not to rescue companies, and to make the exit as smooth and quick as possible. At the same time, we will adhere to the policy of “more mergers, fewer bankrutpcies,” so that more exits of “zombie companies” happen through mergers and restructuring. This will result in appropriate placement of workers, reduce the impact on society, reduce the economic risk, and raise the quality and efficiency of economic development.
China’s SOEs deserve a book in themselves (authored by Matt Taibbi to make it interesting) because they serve so many functions and are critical to China’s ability to keep the economy on an even keel.
Some companies serve a limited purpose. For example, a Province with a big metal extrusion industry bought an Australian bauxite mine and smelter to deliver a predictable product to a defined market at the lowest cost. Such SOEs require little management talent and might, if left on autopilot too long, operate unprofitably. No biggie. What the Provincial economy loses on the swings it makes up on the roundabouts (and taxes). Would you call this a ‘zombie’?
Then there are SEO monsters like National Grid, requiring world-class management/engineering talent. With its own labs and world-leading technology, its vast continental network and its exotic mix of power inputs, it must deliver affordable energy to every home and business in the country. It’s a national treasure, as AT&T used to be, except that it’s publicly owned for the public good. If it didn’t make a dime would you call it a zombie?
There are the SEO banks, monsters in their own way (they’re the most profitable corporations on earth) whose job it is to ensure the smooth delivery of affordable finance to everyone deserving Chinese. Even if they weren’t particularly profitable, though, they’d hardly deserve to be treated as zombies. They’re just utilities, after all, not profit centers.
Instead of allowing all of these SOEs to become rent-seeking private companies, the government distributes that foregone profit to the people in the form of wages: that’s how they’re able to increase wages 100% every ten years. SOEs are China’s secret sauce.