Do zombie firms crowd out healthy firms and slow their growth? Evidence from China

Motivation To prevent job losses, firms facing insolvency in China may be kept running by bank credit, even though they show few signs of returning to profit. These loss‐making firms are termed “zombies”. Purpose Does keeping zombie firms operating block access to credit for financially healthy firms, thereby slowing their growth, and consequently the number of jobs they might create? We analyse the effect of zombie firms within a postal zone—a sub‐division of the county—on the growth of employment in non‐zombie firms in the same zone. Methods and approach Zombie firms are identified as those that have been unprofitable for at least two successive years, and that have a high and rising ratio of liabilities to assets. Data come from China’s industrial enterprise database for 1998–2008 and 2011–2013, gathered from manufacturing, extractive industry, and utilities enterprises with annual sales of more than RMB 5 million (RMB 20 million for 2011 and beyond). It covers between 83,000 and 217,000 firms for the years examined. We use regression to examine the relationship between the presence of zombie firms and employment growth in healthy firms. We test the robustness of the analysis. Findings Between 1999 and 2013 the share of firms in the database classified as zombies fell from almost 10% to under 3%. Regression analysis shows that the presence of zombies in the same postal code does indeed slow the growth of employment in healthy firms. This effect is stronger for private firms, small firms, and those located in central China. Results are robust when considering start‐up firms, analysing relations at county level, and checking for endogeneity. We show that the most likely mechanism that slows the growth of healthy firms is being crowded out of credit markets by banks that allocate their limited credit to keep zombies operating. Policy implications While it is tempting for government to pressure banks to keep zombie firms operating, thereby avoiding them shutting down with loss of jobs, the cost is high in slowing the growth of financially healthy firms. Banks should offer credit based on expected returns and risk, rather than keeping insolvent firms going. Local and national government should take note that protecting zombie firms has medium‐ and long‐term costs in lost growth of employment.