Rising Chinese Zombie Firms

Have you ever looked up and wondered where the time went? One moment you’re living your life, and the next moment you realize that you’ve just lost time that you’ll never get back? That’s what happened to Japan’s economy at the turn of the century in an episode that’s known as ‘the lost decades’. It was a period of slow or null economic growth. Economists differ with their explanations. One cause was the prevalence of ‘zombie firms’.

Japan’s Economy

Japan had a current account surplus from 1980-2020, which means that they had more savings than they effectively utilized domestically. Metaphorically, they were so full of savings that they exhausted productive domestic investment opportunities and their savings spilled out into other counties in the form of foreign investments. This was driven by high household savings and slow growth in domestic investment demand. The result was the Japanese firms had easy access to credit. Maybe a little too easy…

Private corporate debt ballooned throughout the 1980s. That’s not intrinsically a problem. In the 1990s, households began saving somewhat less, and most firms began to drastically deleverage… But not all firms. The net effect of the mass deleveraging was that interest rates fell. The firms that remained in debt were the ones that risked insolvency. Less productive firms had slim profits and their Earnings Before Interest, Taxes, Depreciation, and amortization (EBITDA) was slim. So slim, that they couldn’t pay their debts. Faced with the prospect of insolvency, firms did what was sensible. They refinanced at the lower interest rates. Firms went to their banks and to bond markets and rolled over their debt, which they couldn’t afford, and replaced it with debt that had a lower interest rate. This occurred across industries, but especially in non-tradable goods and services that were insulated from international competition. Crisis averted.

Except this process of refinancing, while avoiding acute defaults and a potential financial crises, ensured that the less productive firms would survive. Not exactly failing and not exactly thriving, they could sort of just hold on to something that looks like life. Well, high debt and low profits aren’t much of a life for a firm. It’s more like being undead – like a zombie. Between 1991 and 1996, the share of non-finance firm assets held by zombie firms ballooned from 3% to 16%. The run-up differed by industry: Manufacturing zombie assets rose from 2% to 12%, from 5% to 33% in real estate, and from 11% to 39% in services. These zombie firms linger on, tying up valuable resources with low-productivity activities and drag on the economy.

China’s Economy

I’m not prone to China hysteria generally. However, I do have uncertainty about the plans and actions of the Chinese government because I don’t know that domestic economic welfare is its priority. That makes forecasting more political and less economic and outside my expertise. Regardless, the Chinese economy is a constraint on the government, whether they like it or not. And there are some echoes of the Japanese economy’s lost decades.

China has had a current account surplus since 1994. Chinese households save enough to satisfy domestic investment and invest the balance elsewhere. Private non-financial debt increased substantially in 2008-2016. Chinese interest rates have been more or less constantly low since 2016. The Chinese government has also announced a battle against ‘involution’, which they characterize as profit-jeopardizing price competition. In other words, there are firms out there that are limping along with low EBITDA. Among Chinese industrial firms with above-median asset growth, 34% don’t make profits. Of the industrial firms with the slowest growing assets, 29% don’t make profits.

Between 2016 and 2024, the zombie firm share of assets across the non-financial sector increased from 10% to 16%. The run-up differs by industry: Manufacturing zombie assets rose from 9% to 11%, real estate rose from 15% to 40%, and services rose from 11% to 17%. So, not as drastic as in Japan, but an echo all the same.

When zombie firms started to grow in Japan after 1990, the RGDP per capita was $28k vs $39k in the US. Japanese RGDP per capita had grown at an average annual rate of 3.9% during the preceding decade. Since then, it’s grown by only 0.8% per year.

We can make similar comparisons with China since 2016 using the data that we have so far. Chinese RGDP per capita grew at an annual rate of 9% between 1990 and 2016. Since 2016, it’s grown by only 5.3%. That looks healthy to American eyes. The difference is that when Japan stagnated, GDP per capita was already 73% of US GDP per capita, firmly in high income territory. China’s growth started slowing in 2016 when their income per capita was only 15.2% of the US. In 2024 it was 19%. That’s still low-middle income territory. As much as economists want the Chinese people to be prosperous, the slowing growth is not a surprise to many economists who were skeptical of the more heavy-handed Chinese style of a mixed economy.

Importantly, this is not a doomsday post. China is not hurtling toward oblivion. However, its economy has slowed and the heightened proportion of zombie firms is concerning. The open question is whether the government will effectively ‘manage’ an unraveling of the zombie firms in order to avoid slower productivity and economic growth. While there is plenty of cause for concern about the goals of the Chinese government, it concentrates resources from a still relatively poor population with slowing economic growth.