China's avoidance of market rules have given rise to bloated, wasteful and debt-laden state-owned enterprises that continue to be funded despite their lack of merit. An overhaul of these must be on tap to improve the country's stagnating e
BEIJING — China is at a critical economic juncture, weighed down by what are known as "zombie enterprises," unprofitable, debt-ridden companies that tend to be state-owned and that require constant bailouts. Premier Li Keqiang even told a recent meeting of executives that the government will be serious about its recent reform policy to "restructure" these companies and to respect the law of the market.
Zombies obviously contradict the market rule of survival of the fittest. But because of certain dominant forces, they have formed a self-perpetuating cycle in China and have become its economy's titanic iceberg.
Take eastern coastal Zhejiang, China's richest province, as an example. In the past three years, this area alone has accumulated as many as 1,542 such zombie companies and generated nearly 100 million RMB in bad bank assets.
In Shenzhen and Shanghai, such businesses represent 10% of all listed companies. They are widespread in industries where overcapacity is severe, such as iron and steel, petrochemical, machinery, cement, coal and textile.
So why are they so prevalent in China? Mainly because local governments rely on them for their political vanity and for social stability.
China's giant central state-owned enterprises have a monopoly on sectors such as energy, finance, telecommunications and high-quality resource products. So what's left for the majority of local state-owned enterprises and large private companies is limited to public utilities and to particularly competitive fields. These fields are either unprofitable or have low profit margins. But to boost local economies, authorities still encourage large investments through incentives such as preferential tax relief, land grants and financial support.
Once an economic downturn occurs, these investments can very quickly become burdens on the local enterprises. Yet local authorities won't allow them to merge with other businesses from outside of the region. Nor will they let them go bust because this means they would lose their direct or indirect control of the companies. That coupled with tax revenue losses would eliminate any political achievement. There is also the headache of having to deal with the consequent mass unemployment and the threat of instability after a shutdown.
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Factory workers in Huangyan, eastern China — Photo: every one
China's distorted financial support for these zombies is also to blame. In China, most major revenues for state-owned banks come from deposits and lending instead of from financial services. Meanwhile, their method of identifying risk is very different from that of advanced countries. They cast a dismissive eye on small- and medium-sized enterprises, which they consider as intrinsically risky, in favor of large organizations, no matter their fiscal health.
In other words, financial resources don't follow a meritocracy and aren't allocated in accordance with market logic. Once the mismatch has occurred in a sector with overcapacity, banks continue to pump in more resources, expecting that the risk is not exposed in a short term.
Restructuring China's zombie companies primarily involves reforming state-owned enterprises and pushing forward a bottom-up, market-oriented approach. The reason it's been difficult is because local governments all have a say. The role of local government should be as the incubator of new economic momentum, instead of in directing how enterprises are run.
Finally, China's financial system needs to accelerate and promote market-oriented reforms, enhancing risk identification for banks. It needs to play a supportive role in the multi-level capital market and guide the rational allocation of financial resources. If the Chinese economy is to avoid derailment or stagnation, a painful overhaul of its bloated companies is desperately needed.