China’s Zombie Firms Can’t Lurch Forever

As state-backed companies' debts mount, China faces an inevitable slowdown.

A Chinese worker loads coal into a furnace on November 3, 2016 in Inner Mongolia, China. (Kevin Frayer/Getty Images)
A Chinese worker loads coal into a furnace on November 3, 2016 in Inner Mongolia, China. (Kevin Frayer/Getty Images)

China National Erzhong Group’s factory campus is not what you’d expect of China’s highly touted military-industrial complex. Old men in faded blue overalls squat while weeding the pavement in the steamy Sichuan heat, fighting a losing battle against the vines and creepers that have already taken over the older factory buildings. Around midday, the place empties out as workers go home for their 2½-hour lunch break. Bicycles leave first; cars are allowed to follow 15 minutes later.

Retirees living in old company-allocated apartment buildings that skirt the campus grow vegetables on unused land at the base of the factory walls. And the factory’s first generation of managers, now in their 90s, live with their children and grandchildren in a handful of villas shaded by trees growing kumquats and ball-bearing-sized huajiao, the mouth-numbing spice used in Sichuan cooking.

Erzhong — literally “second heavy,” as in China Second Heavy Machinery Group — started life as an offshoot of the Chinese Red Army. In 1958, workers from China’s northeast, the country’s industrial heartland and the home of First Heavy, were relocated to Deyang in western Sichuan province to make large-caliber artillery at what was deemed a safe distance from the Soviet Union in case China’s onetime ally decided to invade. Even today, the thick, guttural drawl of the northern transplants and their children sticks out among the lispy pronunciation of the native Sichuanese.

But, for all its backwater charm, Erzhong is part of the backbone of China’s industrial infrastructure. No longer just a defense contractor, it makes entire steel mills and most of the parts needed to build a nuclear power plant. It makes crankshafts for cargo ships and the blades for hydroelectric power turbines, pieces of metal so large that diesel locomotives are needed to move them on train tracks between factory workshops.

The company’s proudest achievement, however, towers 10 stories over the otherwise squat compound. Housed in a gray-and-red prefabricated hangar with a glass viewing platform on one side is the world’s biggest closed-die hydraulic press forge, a 22,000-ton steel behemoth that China hopes will allow it to technologically leapfrog the United States when it comes to engineering the next generation of military hardware. The machine was built specifically to produce metal components like bulkheads, landing gear, and engine parts for China’s Air Force and commercial passenger planes. Advisors on the project say it could also be used for manufacturing aircraft carriers, armor plating, spacecraft, and high-pressure mining tools. Crucially, it was built to produce a record 80,000 tons of pressure and create pieces of metal that are bigger, stronger, and lighter than anything the United States is currently capable of producing.

But when I visited the forge in 2014, it was clear that China didn’t have much need for the world’s biggest forge, and it was the sitting idle. It wasn’t Erzhong’s only white elephant. Not long before, Erzhong had been taken over by another state firm, a humiliating bailout for the storied company after a string of wasteful, big-ticket investments had left the company drowning in debt.


In recent years, China’s state-owned firms have emerged as a symbol of China’s strength and of the West’s relative decline. Beijing uses them as tools with which it can make long-term strategic decisions at a time when the West has neither the budgets nor the political bandwidth to similarly invest in the future. China’s state firms build products that are too risky for the private sector to take on, like large passenger aircraft, which such firms have been working on for years with the goal of one day breaking Boeing and Airbus’s duopoly.

State firms are used to buy up natural resources around the globe that are important to China’s development. They build infrastructure in developing countries, a core part of Beijing’s foreign policy aimed at cultivating friendly nations. Sometimes they are mobilized to defend China’s economic interests, as when Aluminum Corporation of China, or Chinalco, spent $13 billion in 2007 buying Rio Tinto shares to stop the Anglo-Australian mining company from merging with BHP Billiton, a merger that could potentially have made it more difficult for China to negotiate prices for iron-ore imports by combining two of its three biggest suppliers.

What is easy to overlook is that all this comes at a cost. The Comac C919, the single-aisle plane that is supposed to challenge Boeing and Airbus, has been a money pit and is years overdue. Buyers were originally supposed to start taking delivery of the plane in 2014. That’s been pushed back to 2018, but delivery could be as late as 2020, and the plane could be outdated even before it arrives. Rio Tinto’s shares have traded at less than half of what Chinalco paid for them for most of the time since it acquired them. While China’s state companies regularly outbid foreign firms to buy overseas mines, they also routinely overpay for the privilege. Many of the countries where China has built infrastructure are now struggling to repay those loans and have grown increasingly wary of Chinese influence. And in western Sichuan, $317 billion was spent on a forge that’s hardly been used.

“China now has the biggest forge in the world, but it’s not the most advanced,” says Yan Yongnian, a former professor of manufacturing automation at Tsinghua University who was part of the group of advisors put together by Erzhong to consult on the machine’s development. He wasn’t invited back after his second visit. “I had a difference of opinion with the company,” he tells me. Yan’s issue was that the forge lacked the controls of more modern machines and so wasn’t as accurate as it needed to be. Yan blamed the company culture. Rather than innovate, it had modeled the forge on old Russian designs from the 1980s. Since then, forging technology has grown more complex. Forges need to respond quickly and regularly to changes in the metal to ensure that the grain ends up flowing in just the right way. Alcoa’s Cleveland forge recently underwent a $100 million upgrade to ensure that it continues to remain state of the art.

Yan says that politically it was safer for engineers at Erzhong — an organization in which thousands of Chinese Communist Party members routinely meet in small groups to discuss Marxist-Leninist-Maoist thought — to use a tried-and-tested old design than to come up with something new. In other words, there’s no culture of risk-taking. “If you copy something word for word, then it’s not your fault if something goes wrong,” Yan tells me.

Just a year after the forge was fully operational, it was clear that China didn’t need the world’s largest forge. The United States has been able to get by with forges little more than half the size of Erzhong’s since the 1950s, and China is nowhere near producing aircraft the size of Airbus’s A380. China’s smaller forges — like the more technologically advanced 40,000-ton forge launched in Wuhan a year prior to Erzhong’s — are capable of producing anything the Chinese military or industry currently requires.

Moreover, what was anticipated as being the forge’s main source of business never materialized. During its launch ceremony, the first component the forge manufactured was the landing gear of the C919 passenger plane, but so far the C919 has failed to generate regular work for Erzhong, and perhaps never will. “There’s currently an excess of large forges, and there’s just not enough work to go around,” Zeng Fanchang, an advisor on the project, tells me.


State firms might account for only a quarter of the Chinese economy, but they’ve borrowed almost 60 percent of the country’s corporate debt. China has little mortgage debt relative to the United States, and official government debt is very low, but China’s companies — and in particular its state-owned companies — have borrowed incredible amounts. According to the consulting firm McKinsey, between 2007 and mid-2014, China’s companies — both state and private companies combined — went from owing $3.4 trillion to $12.5 trillion, a faster buildup than in any other country in modern times.

Still, the question commonly posed is, if most of China’s corporate debt is government-owned, why should anyone worry about it? Certainly, China’s state companies don’t seem to. Shi Changxu, the father of Erzhong’s forge, says that before the state economic planning agency gave the project the green light, there was much debate over whether there would be enough work to justify building such a large machine. In the end, they decided it didn’t matter. Self-sufficiency was more important than efficiency.

Today, Erzhong is a zombie, a company that doesn’t generate enough revenue to repay its debt and is being kept alive by the willingness of banks to keep reissuing new loans. The term “zombie company” was originally coined to describe Japanese companies that were being kept alive after Japan’s property-market collapse in the early 1990s, but in recent years “zombie” has gained currency among Chinese officials as well.

Chinese pop culture has a zombie tradition that differs a little from the brain-eating undead version that has been the U.S. standard since George A. Romero’s Night of the Living Dead. China’s zombies — or jiangshi, “rigid corpses” — trace their lineage at least to the Qing dynasty.

They’re as much vampire as zombie, craving blood rather than brains. And, in a markedly different take on how rigor mortis affects the dead’s perambulatory skills, they get about using a two-footed hop rather than staggering and slouching their way forward like American zombies. The differences between U.S. and Chinese zombies spill over to include the corporate variety, with the Chinese displaying an unhealthy willingness to accommodate the undead among its firms.

“It’s not easy, but we need to find a way to lift their vitality,” Premier Li Keqiang said of China’s zombies in 2015. “We need to avoid having zombie companies, we need to help them, to let them live and live well.”

At the heart of this tolerance is a fear of instability. Social stability has been the overwhelming preoccupation of the CCP for the past decade. Massive amounts of money have been dedicated to improving surveillance, monitoring social media, and beefing up internal security. Local officials are expected to maintain social stability over and above all other responsibilities. Regardless of how successful an official has been at generating growth, one protest above a certain size automatically puts an official’s promotion prospects on ice. Social instability, very broadly defined, is the one thing that renders all other achievements moot, providing officials with the motivation to keep companies alive, their workers employed, and their pensions intact.

That said, not all company failures are as destabilizing as others. Factories run by private firms routinely go out of business, with workers often learning that they’re out of a job only when they turn up to work to discover the gates locked and the managers have vanished.

But private-sector factories are relatively easy to deal with when they shut down. Their employees often tend to be migrant workers, people who are required by law to leave the city and return to their homes in the countryside if they can’t find work. State firms, however, are different. Their employees are usually locals who have nowhere to go if they lose their jobs and are more likely to protest. And state companies are often the linchpin of the local economy, with whole towns being built around them, such as Deyang, where Erzhong is based.


“In the last one or two years, I haven’t taken anyone around for a tour. No media, and certainly no investors. They just don’t have any interest in the company,” Liu Shiwei, a public-relations official for Erzhong, says to me when I visit the factory in the summer of 2014. By the time we sit down in his office, overlooking the lunchtime exodus of workers through Erzhong’s main gates, Liu has shed any pretense of trying to spin the company’s predicament. Erzhong was listed on the Shanghai Stock Exchange, but after years of not making a profit, its removal was just a matter of time — it was finally ejected a year after my visit — and Liu knows his job will soon become obsolete.

A child of people who had moved for the company from the northeast, Liu had inherited their accent and had grown up during a time when Erzhong was at the heart of community life. He is clearly nostalgic for Erzhong’s good old days, but it is becoming harder to maintain company pride. Bonuses — no small part of total compensation for Erzhong’s 13,000 employees and the 10,000 retirees it still supported — had dried up along with company profits. “Workers at other companies [in Deyang] are doing better,” says Liu. “Shopkeepers treat them better. When they hear the accent of Erzhong folk, they’re not as welcoming.” Three months after the forge was launched, Beijing announced that it was going to merge Erzhong into another state firm, China National Machinery Industry Corp., or Sinomach. Sinomach does a little bit of everything.

Of its more than 40 subsidiaries, one makes excavators and other construction machinery, which it exports primarily to developing economies. Another makes the components that allow China’s spacecraft to dock with the country’s space laboratory. And in 2010, Sri Lanka celebrated the construction of a coal-fired power plant by a third Sinomach unit by putting an image of the plant on its 100-rupee note.

By 2015, Erzhong had borrowed so much with so little payoff for its investments that without Sinomach’s intervention it would have collapsed. The company’s fortunes had turned for the worse in 2011, when it lost $40 million. Over the next four years, it would cumulatively lose about $2 billion. When I visited, what little work Erzhong had was being done at night so it could take advantage of off-peak electricity prices.

As far as bailouts go, Sinomach did the bare minimum. It paid out investors when Erzhong was on the brink of defaulting on its bonds. It negotiated with the banks that Erzhong had borrowed from to ease the debt burden. It promised to share any innovations its research and development divisions happened to come up with, as well as to introduce Erzhong to other state firms to try to drum up business, and to use its connections overseas to boost Erzhong’s exports. But it hasn’t given Erzhong a cent. “The way to help a company is by restoring it to health, not by giving it a blood transfusion,” says Ren Hongbin, Sinomach’s chairman. “The more you support a company [with cash], the more impoverished it becomes.”

In early 2015, Erzhong’s management tried to downsize, asking workers to take voluntary layoffs and early retirement for a monthly stipend of 380 yuan — about $60, roughly a quarter of the minimum wage in Sichuan. Its workers took to the streets in protest. “We devoted our youth [to the company], and now workers have to pay the price for bad policymaking,” read one banner that was marched through town. “Don’t ask the workers to shed blood and sweat, and now tears,” read another.

“These last few years … no one has asked who is responsible for these losses,” said an Erzhong worker interviewed on foreign television at the time. “It’s really a case of ‘heaven is high and the emperor is far away,’” an idiom meaning management could do as it liked without oversight from Beijing. “State assets have been lost, creating a huge hole, but the central government turns a blind eye, and in the end it’s the workers who bear the brunt.”

Ultimately, however, Erzhong’s workers won’t be the only ones who suffer. China has managed to enjoy such fast economic growth over the past decade because debt has grown even faster — but that’s not sustainable. Projects like Erzhong’s forge generate growth today but drag it down tomorrow. At some point, when debt can’t continue to safely accumulate, China faces the prospect of an economic slowdown just as Beijing is forced to assume the costs — higher inflation, higher taxes, bankruptcies — of cleaning up years of waste. It might not result in a crisis. If China’s lucky, it might even avoid a recession. But it will be a definitive end to the miracle.

This article is adapted from Dinny McMahon’s new book China’s Great Wall of Debt: Shadow Banks, Ghost Cities, Massive Loans, and the End of the Chinese Miracle. Copyright © 2018 by Dinny McMahon. Used by permission of Houghton Mifflin Harcourt Publishing Company. All rights reserved.

Dinny McMahon is a fellow at the Woodrow Wilson International Center for Scholars and a former China-based financial journalist.

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