Zombie Firms and Soft Budget Constraints in the Chinese Stock Market*

• Date: 01 March 2020
• Author: Chenyan Zhang,Yongqiao Chen,Huiyu Zhou
• DOI: http://doi.org/10.1111/asej.12194
• Published date: 01 March 2020

Zombie Firms and Soft Budget Constraints in

the Chinese Stock Market*

Chenyan Zhang, Yongqiao Chen and Huiyu Zhou

Received 28 August 2018; Accepted 16 December 2019

The growth of zombie firms has caused increasing concern. The present study

seeks to understand why zombie firms have been emerging in recent 10 years and

to further explore the mechanisms of their formation. Based on a dataset of Chi-

nese listed companies from 2012 to 2016 and empirical analysis, the present study

ascribes the prevalence of zombie firms to soft budget constraints. After using a

modified identification model in the Chinese context, we concluded that zombie

firms have access to some external resources such as credit support from banks

and governmental subsidies, substantiating soft budget constraints among zombie

firms. To explain this phenomenon, further analysis reveals that zombie firms bear

a heavier policy burden by hiring excess employees, which will bring them more

subsidies and a stronger relationship with government in return. This result indi-

cates that policy burden is the reason for soft budget constraints, which exacer-

bates the zombie firm problems in China.

Keywords: JEL codeG12, G31, G28, G32, C23.

JEL classification codes: G12, G31, G28, G32, C23.

doi: 10.1111/asej.12194

I.Introduction

Zombie firms refer to unprofitable firms that are kept alive by external resources

(which we call ‘soft budget constraints’), like subsidies from the government or

‘evergreen’loans from banks. The rampancy of zombie firms will result in huge

corporate debts and misallocation of social resources, which will distort the

competition throughout the rest of the economy (Caballero et al., 2008).

Through limiting the expansion ability of healthy existing firms, zombie firms

can congest the market, create barriers and hamper the post-entry growth of

young firms (Adalet et al., 2018). To achieve sustainable economic growth in

the future, studying why zombie firms emerge is a top priority.

*Zhang: Beijing Jiaotong University, No. 3, Shang Yuan village, Haidian District, Beijing,

100044, China. Chen: Peking University HSBC Business School, Shenzhen, Guangdong, China.

Zhou (corresponding author): Beijing Jiaotong University, No. 3, Shang Yuan village, Haidian Dis-

trict, Beijing 100044, China. Email: hyzhou@bjtu.edu.cn. This work was supported by the National

Natural Science Foundation of China (Grant No. 61602028).

© 2020 East Asian Economic Association and John Wiley & Sons Australia, Ltd

Asian Economic Journal 2020, Vol.34 No.1, 51–77 51

Following rapid development, China has come to face this zombie firm prob-

lem in recent 10 years. The present paper reveals the mechanisms of for mation

of zombie firms by modifying existing measurements of ‘zombie’firms, then

empirically tests the existence of and reasons for soft budget constraints among

zombie firms in the Chinese stock market.

Scholars have already discussed how to recognize zombie firms. Caballero

defined zombie firms by their lending behaviors with banks (2008). It was not

until recently that scholars began to research zombie firms in China. Scholars

have found that regulatory policies have a direct effect on the creation of zombie

firms in China (Wan-Jun et al., 2018). The crowding-out effect on private invest-

ment as a result of zombie firms has also been explored (Tan et al., 2016). Zom-

bie firms have caused and worsened overcapacity problems by crowding out

normal companies (Shen and Chen, 2017).

The soft budget constraints originated from the phenomenon of government

continuously rendering financial help (e.g. increasing investments, and providing

tax redemption or subsidies) to unprofitable state-owned enterprises (SOEs).

Soft budget constraints mean that there is excessive expenditure over earnings,

which will be paid by other institutions. Budget constraints could be further

softened when managers of SOEs have anticipated help from the government;

thus, they no longer operate cautiously, resulting in more loss and subsequent

financial assistance. Politicians have an incentive to provide subsidies in

exchange for economic decisions by SOEs that are favorable to politicians’

careers (Vishny, 1994). Apart from state-owned property, the asymmetric infor-

mation about a project is also proven to be a main reason why soft budget con-

straint exists (Dewatripont and Maskin, 2003).

After observing the fact that SOEs in many developing countries still have

soft budget constraints even after privatization, Lin et al. (1998) attribute soft

budget constraints to firms’policy burden. Policy burden is imposed by the gov-

ernment, which hopes firms can maintain social stability by employing more

employees or, for instance, using advanced machines to catch up with leading

international companies. In return, the government softens their budget con-

straints when necessary. State-owned banks dominate the Chinese banking sys-

tem (Bailey et al., 2011), resulting in a strong connection between politics and

finance. A cross-country study by Faccio (2006) showed that firms have easier

access to debt financing while enjoying lower taxation and interest rates when

the government decides to rescue a particular industry or financially distressed

firms with political connections. Therefore, the government plays a crucial role

in determining whether politically connected firms have access to subsidies or

credit support.

Previous studies on the identification of zombie firms and their budget con-

straint problems are insufficient. Previous identification methods have been

mainly based on Japanese experience, which is quite different from the Chinese

context. For instance, in Chinese accounting practice (International Financial

Reporting Standards rule), extraordinary items (e.g. subsidies and capital gains)

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