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

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 firms 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 refinance an insolvent borrower. An optimistic expectation is essential in zombie lending and is intrinsic to the countercyclical pattern of zombie firms. Our model also predicts that debt can build up to an unsustainable level if recovery of profitability 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 firms 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.

The Effects of Green Credit Policy On The Formation of Zombie Firms: Evidence From Chinese Listed Firms

“…(ii) Bank loans are a pre-existing behavior, and the formation of zombie firms is an after-event behavior. The pre-existing banks' overly optimistic expectations of corporate profits have caused zombie firms (Zhu et al 2019). (iii) Regulatory forbearance towards banks may lead to an increase in zombie lending practices (Chari et al 2021).…”

Can pay‐performance sensitivity cure zombie firms? Evidence from China

“…Chinese scholars proposed a further improved method based on the fact that government intervention is the most important reason for the formation of zombie firms in China, adding the factor of government subsidies to the FN‐CHK method (X. Y. Dai et al, 2019; Huang & Chen, 2017; Y. Q. Wang & Zhu, 2020). For the causes of zombie firms' formation, most scholars believe that the continuous ‘blood transfusion’ of banks to zombie firms is the main reason for the formation of zombie firms (Fukuda et al, 2006; Hoshi & Kashyap, 2011; Peek & Rosengren, 2005; Watanabe, 2011; Zhu et al, 2019). On the contrary, Chinese scholars found that a combination of market and policy factors is the main reason for such formation in China (He & Zhu, 2016).…”

“…Wang & Zhu, 2020). For the causes of zombie firms' formation, most scholars believe that the continuous 'blood transfusion' of banks to zombie firms is the main reason for the formation of zombie firms (Fukuda et al, 2006;Hoshi & Kashyap, 2011;Peek & Rosengren, 2005;Watanabe, 2011;Zhu et al, 2019). On the contrary, Chinese scholars found that a combination of market and policy factors is the main reason for such formation in China (He & Zhu, 2016).…”

Zombie “Landing” On Local Labor Markets

“…On the other hand, Ogawa and Kitasaka (2000) and Giannetti and Simonov (2013) propose an alternative explanation: lending to firms in need enables banks to maintain good customer relationships and networks. That is, lending to zombie firms can be an "optimal strategy" to the banks, especially in Japan when there is a close bank-firm relationship (Jaskowski 2015; Bergant and Kockerols 2020; Zhu et al 2019).…”

“…They find that credit misallocation might not have any significant impacts on the growth of healthy firms and TFP after addressing the deficiencies from the original model. In addition, empirical evidence from Japan, China, and Europe has all shown that most zombie firms left the market voluntarily; furthermore, most of those that stayed became profitable again shortly after the economy recovered (Fukuda and Nakamura 2011;Zhu et al 2019; Banerjee and Hofmann 2020; Goto and Wilbur 2019). Therefore, while zombie lending is costly in the long run and should be avoided, it appears to be the case that zombie lending can be temporary financial help to viable firms.…”