Slaying China’s “Zombies” and Righting the Economy

Recent signs show that the Chinese economy, which has maintained double-digit growth for three decades, is slowing down. China recorded its last double-digit growth in 2010. But since then, the annual growth rate has fallen roughly 20 percent (from 10 to 8 percent per annum). The GDP data for the first quarter of 2013, if anything, have raised fresh worries. Instead of expanding at the expected rate of 8 percent, the Chinese GDP grew 7.7 percent. Such growth may be the envy of the rest of the world. But in China this number has been greeted with

Minxin Pei

However, the new Chinese leadership appears to be unmoved by such panicky calls for imprudent policy moves that could worsen the structural distortions in the Chinese economy.

This kind of patience has dampened the hopes of real estate developers, state-owned enterprises, and local governments. They desperately want Beijing to bail them out with new loans and fiscal spending, as happened in 2008-2009, when the Chinese government adopted a massive stimulus program that revived growth amid the global financial crisis but has since left behind huge excess capacity in manufacturing, unprofitable infrastructure projects, and significant increase in risky loans in the banking system.

Having learned its bitter lessons from the last round of ill-advised economic stimulus, the new Chinese leadership seems to prefer structural reform to quick fixes. If this is the case, they should take bold actions by capitalizing on the economic slowdown to push through the reforms that will fundamentally transform the Chinese economy.

Of the most urgent reforms China needs in order to sustain growth in the future is removing the massive overcapacity in its manufacturing sector. Because of overinvestment in steel, cement, automobile, and practically all other manufacturing industries, profitability in these sectors is either very low or negative. The result is an industrial landscape dominated by “zombie firms” – companies that should go bankrupt but continue to survive through bank loans and other government subsidies. As long as such firms remain in business, they will continue to sell their products below cost, creating a vicious cycle that destroys profitability for everyone. Needless to say, this situation will also create trade wars with the rest of the world because these firms will try to dump their products on the world market at any price. If allowed to survive, such “zombie firms” will prevent creative destruction, making it impossible for China to become a more innovative and dynamic economy.

To get rid of such “zombie firms,” the Chinese government must rely on market forces, not administrative measures. Traditionally, the National Development and Reform Commission (NDRC), the powerful agency in charge of industrial policy and investment approval, selects firms to be closed or merged. This process is fraught with politics. Targeted firms typically pressure the politicians in their jurisdictions to lobby the NDRC to keep them in business. As a result, many such “zombie firms” are spared. That is one of the reasons why excess capacity is a chronic feature of the Chinese economy.

A more effective way of killing “zombies” is to rely on market forces. Beijing should instruct its banks to stop making loans to such “zombies.” Cutting off their access to working capital will ensure their instant demise. Healthy private firms should be allowed to purchase the assets through an auction process. Of course, given the nature of the Chinese political economy, such an auction process will not be completely clean. But corruption is a small price to pay if this painful workout will destroy “zombies” and create dynamic and competitive private firms.

The same pro-market approach must be applied to the solution of the real estate bubble. At the moment, second and third-tier cities have a huge inventory of unsold apartments (largely because of their inflated prices). Such excess supply can be addressed by forcing the developers to sell at significantly discounted prices. At the moment, the State Council relies on ineffective administrative measures (such as restrictions on the number of apartments Chinese people can purchase) to keep housing prices down. A far more effective approach would be to instruct Chinese state-owned banks to call in the loans to overstretched developers. Those who cannot pay back their loans will have their property holdings liquidated. This process will allow the Chinese government to take control of tens of millions of housing units and sell them to ordinary people at steeply discounted prices. Such a move will kill two birds with one stone – deflating the housing bubble and solving the problem of affordable housing. One obvious concern is that this solution will force Chinese banks to recognize a huge sum of non-performing loans. But this should be no more than an accounting exercise because many of the loans made to real estate developers are for all practical purposes non-recoverable.

In the short term, these two bold measures will likely further depress the Chinese economic growth. But they will make the economy healthier in the long run. Normally, most politicians would shy away from this politically risky strategy. Since the new Chinese leaders have declared that they would accept short-term pain in order to achieve long-term prosperity, they will have no alternative but to embrace such bold reforms.