China is at risk of nurturing “zombie companies” as the economy continues to slow and banks are compelled to continue funding failing businesses, warns independent economist and former Morgan Stanley’s Chief Asia-Pacific Economist Andy Xie.
In a bid to counter slowing growth, Xie says local governments across China are pressuring lenders to keep businesses funded, regardless of profitability, perpetuating the so-called “zombie firms.” These are companies which are on the brink, but continue to operate with state support.
“The Chinese banking system doesn’t pull money out of businesses that are failing. A lot of businesses in China are going to be zombies,” Xie, a well-known China bear, said on CNBC Asia’s “The Call” on Wednesday. “This is an Asian thing because they (banks) don’t enforce credit agreements.”
The trend could become more pronounced as the country’s slowdown sends ripples across the corporate sector. Already, the current earnings season is shaping up to be arguably the worst in history, with major firms in sectors ranging from banks to airlines posting double-digit profit declines.
Xie says the zombie phenomenon is especially prevalent in the real estate and financial sectors, where local governments have been known to actively lend financial support.
While putting companies on life support can preempt disruptive bankruptcies, Xie says it comes at the expense of economic stagnation.
In an article written for a Chinese news publication earlier this year, Xie noted that “China will probably avoid widespread business bankruptcies – normally deemed necessary for cleansing balance sheets and consolidating supply — by forcing banks to prop up unprofitable businesses. (However), this will act to suppress the economic growth rate.”
The slowdown will in turn prevent a recovery in earnings and continue to drag on China’s stock market. The benchmark Shanghai Composite is the worst performing index in Asia this year, down 6 percent.
“Chinese companies have a problem – they are pretty leveraged and have fixed costs. So when their economy slows down their earnings tend to go down dramatically,” Xie said. "That’s a problem dogging Chinese stock market for a long time (now)."