China Is Mass Producing 'Zombie Companies' And They're Eating Away At The Economy



Empty warehouse

Official numbers suggest that the Chinese banking system's ratio of non-performing loans was unchanged at 0.9 percent in the second quarter.

However, the unusual amount of calm implied by the data masks the major risks that are forming in the Chinese economy.

In a report, BofA analyst Winnie Wu writes that "mismatching NPL pictures from top down and bottom up" are concealing a major risk to the Chinese economy – the proliferation of "zombie companies" being propped up by the China's banking system.

At a time when investors are worried about a hard-landing, these zombie companies are holding the country back from real economic growth and threaten to throw the economy into a painful lost decade reminiscent of Japan's experience.

The government is keeping zombie companies on life support

As the Chinese economy slows, the weakest businesses are struggling to keep their doors open. When they fail to repay the loans they have taken out from the Chinese banking system, the companies should go bankrupt and the banks should have to write off the loans and take a loss.

Wu explains that the Chinese government is not allowing this process – the flushing out of bad debts – to occur. Instead, it has forced banks to continue lending money to failed businesses far past the point where they demonstrate any ability to repay the debts.

In other words, Chinese banks, at the behest of the government, are pumping money into dying companies with "no commercial viability," according to Wu.

Official data conceals the rise of zombie companies in China

Although there have been a few high-profile restructurings in China, the bankruptcy landscape has been pretty quiet. Wu says she was actually surprised by the latest data on bad loans from the CBRC because they seem to be massively understating the problem:

"The NPL formation seemed to be surprisingly low, given the recent news related to bad debts: Zhongjiang Group, which reportedly filed for bankruptcy, had 3bn loans from CCB. Jade Cargo, an airline which reportedly entered liquidation in June, had 3bn loans from BOC. Rongsheng, the largest private shipbuilder, had 18bn in loans banks are nervously watching. In the troubled solar sector, the top 10 players collectively had 111bn of debts. The relatively few cases seem to suggest that the amount of potential risky loans may be much higher than the reported NPLs."

Meanwhile, bad loans in Wenzhou, a city in China's Zhejiang province known in financial circles as ground zero of China's ominous shadow banking system, recently surged to a 10-year high. Wu calls Zhejiang "an early reflection on China's economic challenges," making it important to keep a close eye on.

Wu implies that NPL numbers are being held down ahead of a major leadership transition in the Chinese government that takes place at the beginning of next year in order to ensure social stability, but says it should cause concern "that more 'zombie companies' are being made in the economy."

And those zombie companies are threatening the Chinese banking system

China corporate bond issuance 2012


Banks are throwing good money after bad to prop up zombie companies because the government tells them to do so.

This is causing a deterioration in asset quality on banks' balance sheets, and increases the chances that the government will have to bail them out down the road.

And that's not the only risk zombie companies pose to banks.

As lending standards have tightened, companies have rushed to the corporate bond market to raise funds. According to BofA, corporate bond issuance has surged 70 percent from a year ago – and it's not just healthy borrowers. Wu writes that "many LGFVs and troubled companies (eg LDK and Rongsheng) were able to issue bonds in the past 12mths, when bank lending was tightened."

Unfortunately for the banks, this isn't really a way to decrease the concentration of risk in China's debt markets because the banks still underwrite more than 70 percent of all corporate bonds and outright own more than 50 percent of them.

In other words, Chinese banks face the same risks as bondholders as they do from lending.

If all of this sounds familiar, think Japan

Comparison of leverage in China and Japan

BofA Merrill Lynch
The stresses in the Chinese banking system arising from bad debts are indicative of years of malinvestment in China.

The Chinese leadership is doing everything it can to avoid a "hard landing" by keeping the money flowing to zombie companies.

Wu warns that Japan tried to pursue a similar course of action in 1988 and the results were disastrous:


"Intervention by the [Japanese] government further increased the difficulty for banks to recognize NPLs and foreclose on collateral. Many 'zombie companies,' which need constant bailouts in order to operate, were created...As the economy was 'zombiefied,' banks suffered a decade-long crisis with waves and waves of NPLs resulting from the continued capital misallocation."

Zombie companies point to a fundamental flaw in China's growth model, according to Wu. As labor costs in China rise and the country's manufacturing competitiveness erodes, it will need to find new sources of growth.

The bottom line: Wu writes that to achieve newer sources of growth "it is inevitable and necessary to allow the failure of some uncompetitive companies, so as to release the capital and labor to more promising industries."

And China just isn't doing it.