Drowning in Debt- Is China’s Economy the Walking Dead

It seems that behind China's phenomenal success in sectors such as electric cars and solar panels, there may be an uncomfortable secret. A secret where for every success story like BYD, there are 20 hidden business failures and that in itself would not be a drama. Bankruptcy is part of capitalism. The problem arises when they don't die completely, when these dysfunctional companies are stuck between life and death, turned into zombies. Companies like this. China forced to keep unprofitable firms alive to save jobs and avoid unrest. The new reality has saddled China with the most loss-making industrial companies since 2001, the tail end of that earlier period of reform. Local leaders laden in debt are rolling out tax breaks and subsidies for companies in a bid to stave off the double whammy of job and revenue losses. What is happening in China is a reflection of something we've already seen in the not too distant past in Japan. At one time, Japan seemed poised to take over the world. Governments like Reagan's were completely terrified because companies like Sony and Toyota seemed to set to sweep the market and wipe out the entire Western industry in one swoop. And what happened in the end? Japan stagnated for 30 years. And we all know the reasons why. Problems in the financial sector, a large aging population, and of course, an apocalypse of zombie companies that devoured the few resources that the Japanese economy had to offer, leaving truly productive companies without sustenance. Visual Economic Community, many economists believe that exactly the same thing could happen in China. So here on Visual Economic we asked ourselves a few questions. Could China really experience a zombie apocalypse? What is this major problem threatening the Asian giant? Let's find out. In recent months, there is a term that keeps coming up in the Chinese Communist Party statements, involution. It refers to the But beware, because prices are not falling because these companies have become super efficient in their production. Not at all. They are competing at the expense of sacrificing their profits. And even they are not able to sell the products they manufacture. Take note, capital productivity is in freefall, dropping from 17.5% in 2010 to the current 12.5%. What does this mean? It means that despite the fact that Chinese companies have conquered sectors with extremely high added value over the last decade, the productivity of the economy as a whole doesn't seem to be improving. Quite the contrary, in fact. And there is a very simple explanation for this. Due to this involution we have mentioned, for every super successful company, there are a dozen zombie companies. Believe me, we're not just saying this for the sake of saying it. BYD and Xiaomi, to name just two, are true titans. They manufacture a lot, cheaply and with high quality. But here's the problem. They're competing with companies that, well, shouldn't even exist. Companies that are not profitable, not even close. And the worrying thing is that the situation has gotten worse in recent years. So the question is inevitable. Why don't they go bankrupt? Are they waiting for their moment of glory? Or are we talking about the truly undead? The answer lies in credit. For two decades, real estate was the driver of the Chinese economy. But you know how these stories end. Cinderella's magic runs out and the carriage turns into a pumpkin. Evergrande, one of the real estate giants, went under and many others were left hanging by a thread. That's when Xi Jinping said enough was enough. He decided to cut off the credit that banks, mostly public, were giving to the real estate sector. But take note, Chinese credit is like energy. It's neither created nor destroyed, only transformed. Specifically, it was transformed into money for factories. Housing took a back seat and the industrial sector took centre stage. Has this zombified Chinese industry? Well, we don't know yet. It's too early to tell. Is there really enough demand for all these solar panels they are manufacturing, as if there were no tomorrow? Or will they end up gathering dust in empty warehouses? For now, no one can say. What we do know is that this isn't the first time China has experienced a credit boom, nor is it the first time we've heard of zombies made in China. If you don't mind, let's take a look at the past, and there's no better place to start than the 2008 crisis. The financial crisis didn't leave the Asian giant unaffected. As you can see on the screen, the authorities responded to the economic depression with a massive credit boom. In 2009, this credit was more than double that of the previous year. And we aren't talking about a one-off injection, but rather an increase that continued in the following years. We're talking about an injection of more than 4 trillion yuan, 12.5% of GDP, in just two years. So where did all that credit go? To the most productive, most efficient companies? Well, no. Nothing could be further from the truth. All studies point to the same thing. That tsunami of credit ended up, above all, in the hands of the least efficient companies, and especially if they were public or had good friends in the party. But be careful, because this wasn't always the case. Before the 2008 crisis, Chinese credit tended to flow where it made sense, to companies that knew how to use it well, those that delivered results. So what changed? The answer lies in what we already mentioned at the beginning of the video, credit became a social policy tool. In the midst of the crisis, the government used money as a large-scale employment program. State-owned companies, for instance, became 40% more likely to receive credit than private ones. Because neither the provincial governors nor the And it seems, whenever there's a boom in public money, there's a boom in corruption. The price to pay? A zombie economy. And one of the best examples was the 10 Industries Revitalization Plan, a flagship program within the post-crisis stimulus package. A huge plan, and executed in record time, just 50 days. So fast that it became a perfect case study. The result? Well, what you might expect. These programs were the perfect breeding ground for zombie companies. In figures, the probability of a company becoming zombified increased by 4%. And the more money they received, the more that probability grew. Now, why exactly did they become zombies? What mechanisms were at play? There are two key factors. The first is the most obvious. Government money is like an adrenaline shot. It doesn't cure the disease, but it keeps the patient breathing. Companies no longer needed to be profitable, they just had to survive long enough to pay the interest and refinance themselves over and over again. But the second mechanism is more perverse. Knowing that the government would bail them out, they stopped worrying about competing. Why innovate if you have a safety net? Why improve if it doesn't matter whether you win or lose? Some become lazy, others simply started gambling wildly. After all, the government would always be there to save them. And the consequence is not insignificant. Take a look at the report published by the International Monetary Fund. TFP in China by 1.2%. This could imply a GDP level loss of up to 2%. However, these results may be interpreted as a lower bound. A 2% drop in GDP is no small matter. Along the same lines, another study reached very similar conclusions. The latest five-year plans, which had an industrial policy much more focused on key sectors than previous ones, increased wasted capital by 6.7%, reducing the economy's proactivity by, wait for it, 4.5%. So yes, the Asian giant already has a lot of experience with credit booms and zombie companies. But it turns out the friendly relationship between China and zombies didn't begin with the 2008 crisis far from it. There was a time when 60% of China's state-owned companies were truly undead. Yes, you heard right. 60%. And we're not talking about Maoist China, but the 2000s. In 1998, state-owned enterprises accounted for 57% of all added value in Chinese industry. Yet, 40% were operating at a loss. Losses that directly equaled 1.2% of GDP, without taking into account the opportunity cost wasted by giving capital to such poor-performing companies. Another 20% barely produced enough to stay afloat. 60% were zombies. By comparison, at the same time, the US had less than 15%, even though the dot-com bubble had just burst. But even in Japan, the country of the living dead par excellence, the percentage did not exceed 20%. Fortunately, in the following years, the Chinese government got serious about privatization. Between 1999 and 2001, 2,000 companies were privatized every day. The result? Pay attention to this data. Zombie companies that were privatized increased their productivity by 30%, more than those that remained government-owned. Yes, you heard correctly. 30%. That's incredible. And keep in mind that it wasn't just the zombie companies that improved. The rest of the state-owned companies that were privatized also became more efficient. Their labor productivity rose by 6%. Not bad, but even so, they improved between 3 and 5 times less than their zombie counterparts. But what's really interesting isn't the number, it's the reason behind it. What caused this jump in productivity? Leverage fell by 18 percentage points and operating margins grew by 10. A sign of down-to-earth management. But the most revealing thing was this. Administrative costs plummeted by 35%. What does that mean? It means that state-owned companies were bloated with staff they didn't need. There were so many workers without a role that many were not even in the production chain. They were plugged in as administrative staff. This is all very consistent with what we've already told you. Government-run companies often functioned as a dam to contain unemployment. Now, is this still the case? Partly, no. The problem has been greatly reduced. State-owned companies still carry weight, yes, but they're concentrated in strategic sectors such as banking and rare earth mining. Outside of these sectors, they're involved in intermediate processes in the production chain. These are areas that do not require too much innovation or business dynamism. However, understanding this problem of zombies, especially in the public sector, is crucial to predicting what might lie ahead. And this is where a major difference between China today and China 20 years ago comes into play. The bankruptcy system. You see, even when the government decides to let a zombie company die, the process is slow. Very slow. An average bankruptcy in China takes a year and a half. That's 50% longer than in the United States. But that's not the worst part. For years, bankruptcy proceedings were handled by local civil courts. And you can imagine, those courts were not exactly a model of judicial independence. The result? If a large company, one of those that employ thousands of people in the region, had to go bankrupt, the trial dragged on forever. And in the meantime, it continued to operate. A true zombie. That's why the central government created specialized bankruptcy courts. And this time, under its own control. Now the big question is, did they work better? Boy, did they ever. The new bankruptcy courts were 35% faster. But above all, they were much more independent. Thanks to them, bankruptcies began to mount. And we're not talking about simply closing down companies, but letting those that should die, die. To free up capital, space and opportunities that other companies knew how to take advantage of. The result? More companies entered the market. More productive and more profitable companies. So, in summary, everything points in the same direction. China has always had a problem with zombie companies. Sometimes due to its public giants tied to local governments. Other times because of Beijing's tight control over credit. Does that mean China has no leading companies? Not at all. There's Build Your Dreams, or BYD, creating wealth and exporting technology. But there are also thousands of companies that do just the opposite, living off the public budget like economic parasites. And keep in mind, not all communist party investments seek profitability. There are sectors, such as national security, where the objective is strategic. The problem arises when you try to implement industrial policy to gain competitiveness, and what you end up creating is a battalion of zombies. In fact, there is one very revealing piece of data. According to economist Jesús Fernández Villaverde, the Chinese growth model is nothing special. Yes, it is different from the West in many ways, but if we look closely, China has followed the same pattern as other East Asian economies. No miracles or magic formulas. What we see fits perfectly into the more classic models of productivity convergence. In other words, China has not reinvented the wheel. But it does have something very, very special. China has indeed invested much more than other neighboring economies such as South Korea, Japan or North Korea. And if it has invested more, why did we say earlier that it has followed the same growth path? Well, it's very simple. Because the return on that investment has been much smaller. So one thing compensates for the other. Mind you, not all of this difference can be explained by zombie companies wasting capital, but it is an important part of the story. Incidentally, according to this study, the Chinese economy is likely to slow down significantly in the coming years. But that's a topic for another video. Anyway, given all this, you can now get an idea of the relationship between China and zombie companies. That said, now it's your turn. Have zombies really been so harmful to China? Or did the positive effects of their policies outweigh the negative ones? Will we see the government take more radical measures to put an end to the undead? Or will most of today's companies actually survive and not become zombies? You can leave me your answers down in the comments. Don't forget that here on Visual Economic we release new videos every week so subscribe if you haven't already to make sure you don't miss any of our upcoming episodes. If you like this video, hit like and I'll see you in the next one. Cheers, see you next time.