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Chinese zombie SOEs will be restructured and closed. Or will they?

First published: 13th December 2015

Last week, the State Council issued a statement declaring that by 2017 state-owned enterprises (SOEs) that habitually lose money in industries with overcapacity and fail to meet designated quality and safety standards would be closed, merged or restructured. As a sort or corollary, it also said that banks will be encouraged to declare and dispose of non-performing loans. This came a week after Premier Li Keqiang has said that China needed to speed up the move to ‘knock out backward industries and zombie firms’, while enhancing corporate performance and resource allocation

So, is there a new determination and strategy to restructure and close zombie SOEs for the first time since since the major reforms of the 1990s that closed 60,000 firms at the cost of 40 million jobs? Or is this just a another iteration of a familiar refrain, suggesting we should remain skeptical, bearing in mind also that this is a far more sensitive time, economically and politically?

The backdrop isn’t auspicious. On the one hand, President Xinping has been talking for over a year about the ‘new normal’ in the economy, that is, a riskier and more challenging environment. The message that the economic model has to change and things have to change could not have been clearer. On the other hand, the enthusiasm with which the government has launched important reform pales next to that with which it has pursued the anti-corruption campaign and measures of political repression.  Zombie SOEs would be a good place to start if the government is willing and able to implement meaningful reforms in the real economy.

They represent a significant part of the reason for China’s escalating level of non-financial sector debt. Total liabilities, including bank loans and bonds, amounted to over 244 percent of GDP in the middle of 2015 or 60% of GDP more than at the end of 2009, according to the latest figures from the Bank of International Settlements. The level is far in excess of any country in the world in China’s per capita income peer group. The liabilities are concentrated among SOEs, but also among local and provincial governments, and real estate developers.

Zombie SOEs, like their Japanese corporate counterparts in the 1990s, depend on continuous flows of credit to remain current on their debt obligations, defer default or restructuring, and survive. Total credit growth has slowed, but is still increasing at twice the rate of money GDP at a time when private sector firms appear to be facing a credit squeeze. It follows, therefore, that financing the zombies is associated with misallocation of credit, and negative macroeconomic consequences for banks, new business formation, overcapacity, deflation and economic growth. On the very optimistic assumption that their ability to service debt is correlated with GDP, zombie SOE debt is growing twice as fast as their capacity to service it. Patently, this cannot go on forever.

The decline in debt service capacity for companies in general is evident from a number of indicators. The aggregate ratio of debt to equity has risen by a third since 2011, the return on assets has fallen by about the same amount, the proportion of loss making firms has doubled to about 12%, and the proportion of companies whose earnings before interest fall short of interest costs has risen from 4 to 14%. The data for SOEs are higher or worse on every count.

The State Council had to extend its statement to include the implications for banks. The scale of bad debt owed by zombie institutions, including for current purposes local governments, to the banking system is not known. Government data suggest that banks’ bad loans rose in October to about RMB 1.92 trillion, or roughly 2% of assets. The real numbers are thought to be much higher. The IMF’s Article IV Consultation Report this year estimated bad debt plus ‘special mention’ loans at 5.4% of GDP, which might put non-performing loans into 10-20% range estimated by independent analsts.

How and when non-performing loans will come to light is also opaque because of institutional blockages to the process of recognition. Under banking regulations, any declaration of bad debt by one bank means all banks have to declare, a practice that encourages different forms of behaviour designed to extending and pretend. For example, banks have been known to extend new loans to repay old debt, adjust loan contracts, and shift bad loans off balance sheet. SOEs and local governments have issued bonds as cheaper alternatives to bank loans. Another blockage to recognising bad debt is the difficulty of disposing of it after the event because of the capacity constraints among national and local asset management companies, or bad banks established to hold and work off non-performing assets.

The State Council’s recognition of a major problem is welcome. Yet since the major reform agenda was announced in China at the end of 2013, recognition of complex problems has consistently trumped implementation of solutions. At a time when the economy is slowing down on a secular basis, and unemployment and labour unrest are rising, capacity shutdowns that go beyond heavy industry and shipbuilding to construction and manufacturing, and rising job losses look like a big gamble. SOE reform is a dog that has not hunted yet. It is doubtful the government will accept the consequences of letting it loose in the next two years.