Zombie corporations have been a serious problem for Chinese economic authorities since at least 2011. But when China's real estate sector entered a prolonged slowdown in 2014, the companies became an even greater risk. A large majority of them are state-controlled (or closely affiliated) enterprises engaged in property-related sectors, including residential and commercial development, infrastructure construction, steelmaking, and iron ore and coal production. Over the past two years, steady declines in real estate activity — which by some measures accounts for over a quarter of China's total economic output — have dragged down income and profits across the thousands of businesses in those sectors. As a result, foundering businesses turned to bank loans and shadow financing to cover the costs of maintaining their workforces, sending corporate debt levels soaring. In all but a few cases, the political imperative to prevent unemployment crises that could fuel broader social unrest — a powerful motivator for China's central and local governments alike — overpowered authorities' desire to reform the economy by letting failing companies fail.
A Staggering Problem
Now corporate debt is the greatest structural threat to Chinese macroeconomic stability. China's ratio of corporate debt to gross domestic product reached 165 percent by December 2015, up from 101.7 percent in 2008, the year before Beijing launched its emergency stimulus drive. By comparison, household and government debt equaled 40 and 22 percent of GDP, respectively, at the end of 2015 (though the government debt figure does not include debt held by local government financing vehicles, private companies responsible for raising money for local government investment since 2008-09). Corporate debt was by far the largest component of China's 247 percent total debt-to-GDP ratio, according to Moody's Investors Service.
Perhaps more concerning is the fact that state-owned enterprises (SOEs) account for 55 percent of total outstanding corporate debt, according to the International Monetary Fund, though they produce only 22 percent of China's total economic output. This imbalance helps explain the state's disproportionate representation among China's zombie corporations. On one hand, SOEs enjoy easy access to bank credit long denied to their private-sector counterparts. On the other, they face enormous pressure from their overseers in local, provincial and central governments to maintain stable output and employment. Combined, these factors give SOEs powerful incentive to keep borrowing and producing regardless of the wider economic costs. While China's private sector has steadily improved its efficiency, productivity and profits, the state sector has, by and large, lagged. In the coal and steel industries, dominated by hundreds of local and provincial state-controlled businesses, the contrast is especially pronounced. In many cases, these companies are too small, and their ties to local officials and banks too tight, for Beijing to control.
A Temporary Solution
The debt-to-equity swap proposal reveals Beijing's efforts to reconcile its growing desire for industrial reform and consolidation with local political and economic conditions. China's central government remains committed to reforming and restructuring Chinese industry, and, in particular, the state sector. At the same time, however, it understands that it can go forward with the measures only as long as the workers affected are taken care of, at least well enough to prevent unrest. Given China's weak economy and slowing industrial profits, that objective will entail finding new ways to temporarily offset borrowing and other costs for deeply indebted enterprises.
To be sure, a debt-to-equity swap program could itself be a means to achieve industrial reform and restructuring. Combined with serious corporate governance reforms and forced consolidations of truly moribund enterprises, the swap could help put struggling but fundamentally sound businesses on surer financial footing going forward. Chinese authorities will certainly try to play up this aspect of the program. Nonetheless, the primary purpose and effect of the swap in the short run will be to reduce borrowing costs for corporations, much as the debt-to-bond swap program for local governments has served mainly to offset localities' borrowing costs. Without corporate governance reforms and industrial restructuring — changes that will depend on deeper adjustments to China's political incentive structure — the swap program would not go far in making Chinese SOEs the pillars of productivity that Beijing envisions.
Like the local government bond program before it, the new swap program will probably come into being slowly. In light of the State Council's announcement, some form of pilot program could well be in place by the end of 2016. But in all likelihood, it will be at least six months and probably longer before a program on a scale sufficient to address China's overall corporate debt exists. In the meantime, China's leaders will struggle to manage the country's corporate bankruptcy risks. If the housing sector falters again in the second half of the year, this will prove an even greater challenge.