Zombie Firms and Debt Accumulation: A Theoretical Framework and Chinese Experience

• Author: Fan He,Qianlin Ye,Shennan Wang,He Zhu,Chen Liang
• Published date: 01 November 2019
• Date: 01 November 2019
• DOI: http://doi.org/10.1111/cwe.12298

©2019 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 104–126, Vol. 27, No. 6, 2019

104

*He Zhu, Postdoctoral Researcher, Peking University HSBC Business School, China. Email: zhuhe235@163.com;

Fan He, Professor, Department of Economics, Antai College of Economics and Management, Shanghai Jiao

Tong University, China. Email: hefan1971@vip.163.com; Shennan Wang, PhD Candidate, School of Banking

and Finance, University of International Business and Economics, China. Email: wangshennan1985@

aliyun.com; Qianlin Ye (corresponding author), PhD Candidate, Guanghua School of Management,

Peking University, China. Email: jennifer.q.ye@gmail.com; Chen Liang, postgraduate, Arts Program in

Computational Social Science, University of Chicago, USA. Email: bjcliang@uchicago.edu.

Zombie Firms and Debt Accumulation: A Theoretical

Framework and Chinese Experience

He Zhu, Fan He, Shennan Wang, Qianlin Ye, Chen Liang*

Abstract

In recent years, as China has grappled with rising debt and broad economic restructure,

the prevalence of zombie firms has become a critical problem. This paper provides a

theoretical framework illustrating the rationale behind the occurrence of zombie rms

from the perspective of banks. We develop differential equations to model a bank’s

expectation and the ex ante estimate that underlies its decision to renance an insolvent

borrower. An optimistic expectation is essential in zombie lending and is intrinsic to the

countercyclical pattern of zombie rms. Our model also predicts that debt can build up

to an unsustainable level if recovery of protability is sluggish or the initial debt burden

is too high. Examining the Chinese experience of zombie firms over 2007−2017, this

paper highlights two findings. First, the share of zombie firms among Shanghai and

Shenzhen A-share listed companies demonstrates a countercyclical pattern. Second, the

positive correlation between zombie share and debt accumulation across manufacturing

sectors sheds light on the link between zombie rms and the rising corporate debt in

China. To deal with the “zombie” problem, the government should carefully weigh its

policies to avoid further distortions because the occurrence of zombie firms may be

inevitable and impossible to eliminate.

Key words: bank credit, China’s debt risk, debt accumulation, over-capacity, zombie rm

JEL codes: D24, E22, G21, G32, O16, O53

I. Introduction

Edward J. Kane coined the term “zombie bank” in 1987 to refer to institutions that were

able to survive only because they could feed on funds through deposit insurance and

©2019 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Zombie Firms and Debt Accumulation 105

their credit was guaranteed by the US government. This analogy was later expanded to

describe rms that were propped up by cheap credit or government subsidies despite

their questionable abilities to earn prot or even cover debts with assets. Japan’s “lost

decade” following the asset price bubble collapse in 1991 prompted booming research

interest in zombie firms. It is reported that their existence hindered efficient capital

allocation, thus lowering Japan’s total factor productivity (Esteban-Pretel et al., 2010;

Kwon et al., 2015). The problem of “zombie rms” and the constant “blood transfusion”

to them were believed to be the root cause of Japan’s long-term stagnation (Ahearne

and Shinada, 2005; Yoshino and Taghizadeh-Hesary, 2016). In the wake of the global

nancial and European debt crises, zombies once again became a signicant concern

in the developed world, as they occupied enormous credit resources, reduced potential

output growth and crippled the economic recovery process (Hoshi and Kashyap, 2010;

Hoshi and Kim, 2012; Bruche and Llobet, 2013; Willam, 2014; McGowan et al., 2018).

Zombie firms first came to the attention of the Chinese government in 2015

against a backdrop of macroeconomic downturn and rising debt. Cleaning up zombie

firms became a more urgent task in the government’s broader attempt to restructure

the economy. According to the ofcial denition given by the Chinese State Council,

“zombies” are firms that are “not in line with the national energy consumption,

environmental protection, quality or safety standards, suffer sustained loss for more

than three consecutive years and do not conform to the restructuring direction” (Ding

and Shi, 2015). In addition, the Chinese government considered zombie rms the main

reason for the overcapacity problem and thus tackling them was critical in the process of

supply-side structural reform.

Given the prevalence of zombie firms, the interesting question is: What is the

rationale behind the rise and the survival of zombies? More precisely, why do banks

engage in zombie lending practices? In the early 1990s, Japanese banks were inclined to

extend credit to otherwise insolvent borrowers in fear of massive non-performing loans

or falling below capital standards (Caballero et al., 2008; Hoshi and Kashyap, 2010;

Lin et al., 2017). Most studies suggested that “evergreening” was a result of regulations,

gambling for resurrection or pressure from governments and public criticism against the

backdrop of nancial crisis. The emphasis on external pressure, however, is insufcient

to explain the widespread presence of zombie rms across countries and time. Recent

studies focusing on the rise of Chinese zombie rms also failed to answer this question,

as they tended to draw attention to institutional causes with Chinese characteristics,

such as state-owned banks or government subsidies (Tan et al., 2016; Jiang et al.,

2017). Shen (2016) attributed the existence of zombie rms to the lack of comparative

advantages, which undermines their viability. Zhou et al. (2018) argued that the 2008–