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Economic Restructuring

Slaying Zombies

Progress on corporate deleveraging is limited, says former minister Li Yizhong. Enterprises need more self-discipline and incentives, not just administrative orders

By NewsChina Updated Jun.1

When applying for college, high school students are reluctant to choose majors relating to the real economy,” stated Li Yizhong, former Chinese minister of industry and information technology between 2008 and 2010, based on the results of his field research, on March 7 during the annual session of the 12th National Committee of the Chinese People’s Political Consultative Conference (CPPCC) in Beijing. Li himself started his career as a worker in 1967 after graduating from the China University of Petroleum in 1966. Since then, he has been engaged in the real economy in different roles for nearly four decades, including leading enterprises, regulating State-owned companies, monitoring production safety and setting policies for major industries.  

In his speech at the 2017 session of the CPPCC, China’s political advisory body, he expressed his worries about the “increasing marginalization of the real economy” in China. Several provincial officials told him during his research that only 17 to 18 percent of new bank loans in 2016 went to industrial investment, with the lowest rate 13 percent. Worse still, investment in the capital market and real estate has replaced industrial activities as the main source of corporate profit. 

The 261 largest Chinese manufacturers only contributed 17 percent of net profits of the top 500 Chinese enterprises in 2016, compared with the 57 percent contribution from the 33 financial institutions also in the top 500. “I am not jealous of profits in the financial sector, but I do think this distribution of profitability is problematic,” he said.  

“Can we rely on imports to meet the daily demand of our 1.3 billion population? This is absolutely impossible,” he stressed in his interview with NewsChina during the CPPCC session. He shared his observations about problems in industrial operation.  
NewsChina: What do you think of the progress on reducing corporate leverage [measured by debt-to-assets ratio or debt-to-equity ratio] in the manufacturing sector so far? 

Li Yizhong: The debt-to-assets ratio of an industrial enterprise whose annual revenue from its main business is above US$2.9 million on average was down by 0.4 percent in 2016 from 2015. This is slight progress, but not much. Many enterprises and sectors are still haunted by high leverage.  

NC: Can turning bad loans into banks’ shareholdings [indirectly via the third party] be used as an important tool to reduce corporate leverage? 

LYZ: Yes, because it worked quite well in similar efforts in the 1990s. However, the key is to select the right enterprises to do this. For indebted companies with reasonable foundations in terms of product lines, management and technology, their bad loans with banks can be changed into banks’ stakes in those companies. This practice eased enterprises’ debt burdens and reduced losses for banks. The assets involved in such deals also become valuable again. This is how the practice succeeded in the 1990s.  

This time, it is crucial to make it clear in the rules that zombie enterprises [firms that are staggering on with government or debt support] are not allowed to do this. As an important measure of getting financial services to support the real economy, it must be used on the basis of market-oriented negotiations among parties involved in the debts.  
NC: While corporate de-leveraging must be conducted, some State-owned enterprises (SOEs) need more funding to raise their equity base to reduce their leverage. This is also an issue attracting more attention than ever. What is your opinion on this? 

LYZ: It is stated in our policy that profits from the operation of State-assets should be used to strengthen the equity base of SOEs, national social security and other weak points in our economy.  

Li Yizhong answers questions during the 5th session of the 12th CPPCC, March 12, 2017

However, some SOEs suffer from high leverage. For example, State-owned power plants have mainly relied on borrowing to build new generators in the last few years. The same is true for airlines that had to buy fleets of aircraft during their launch and expansion. As these sectors have direct bearing on our national economy and living standards, they need more capital from the yields generated from State-owned assets. By improving their capital structure, their leverage will be effectively reduced.  
NC: What are the main obstacles in removing zombie enterprises? 

LYZ: Zombie enterprises are precisely the main targets of the ongoing campaign against overcapacity, excessive inventory and high leverage. By financial standards, zombie enterprises refer to those that have their cash flow exhausted and are thus not functioning. They survive on bank loans or government subsidies. They must be driven out of the market. 
However, zombie enterprises are only a small group among the enterprises in trouble. More are struggling with other problems, ranging from intensive energy or material consumption to poor production safety and quality. It is better to force them to improve their operations and upgrade their production than to simply shut them down.  

All these have been tried, but not enough. The biggest problem is a lack of determination in removing zombie enterprises. There are pains in the process. How can displaced staff be taken care of? How will bad assets be disposed of? How can bad loans be treated? How can debts and credit be restructured? Besides all this, there will be negative impacts on local GDP performance and fiscal revenues. It takes guts and vision for the government to solve all these challenges, no matter how painful it will be.  
NC: Have you been impressed by any of the efforts in removing overcapacity in any particular sector? 

LYZ: On my trip to Hebei Province, I found cement enterprises were doing reasonably well in this regard. They have adopted a well-organized practice of self-discipline. Cement kilns are not used in winter [when pollution is already very serious due to heating in the north of China]. They have also improved their techniques. In addition, the price of cement has been stable, which keeps their business profitable.  

In fact, there were a lot of small and poorly equipped cement plants before in Hebei. The local government told them they had already made huge profits at the cost of resources and environment for at least a decade. They would not lose much if they closed down now. The government also gave them compensation and subsidies to support them to shift to other sectors.  

It is necessary to keep in mind that more damage will be caused if the backward overcapacity is not eliminated before it is too late to do so. Banks should also realize that they have a responsibility to write off some corporate bad loans or restructuring some bad assets, as banks benefited a lot from corporate borrowing in the past 10 years. Banks will still benefit by giving a helping hand now. If enterprises improve their performance after banks become their shareholders rather than creditors of their bad loans, banks can either enjoy dividends from these stakes or cash out.  
NC: What is the most important task for the government in the campaign against overcapacity, excessive inventory and high leverage? 

LYZ: The government should understand the difficulties of those enterprises in trouble, and try to reason with those enterprise leaders about the cost of resources and the environment and the more-than-sufficient returns from that over the years. Only when enterprises are convinced by this rationale, will they have the incentive to close down their outdated plants. Compensation will also make things easier if necessary.  

However, it is also important for the government to be fully aware of what and how much it can do. Its responsibility is to coordinate the efforts of market players in addressing their own issues of overcapacity, excessive inventories and high leverage.  
NC: The structural supply side reform includes not only removing overcapacity, but upgrading towards more efficient, quality production. However, many industrial enterprises and entrepreneurs are more interested in financial gains. How can this be changed at the enterprise level? 

LYZ: Firstly, industrial entrepreneurs themselves must stay clear-minded about what makes a good business. Great companies worldwide, either big or small, have always built their success on focusing on their main business, rather than behaving in an opportunistic way. Secondly, financial soundness is a matter of survival for enterprises. Otherwise, an enterprise will collapse once its business encounters headwinds and its banks call in arrears. Thirdly, an enterprise has no choice but to try to be the champion in its niche market. From a macro perspective, nearly half of core technologies are not held by Chinese enterprises in many sectors. Enterprises need to invest in their own research and development teams. They cannot just rely on major national R&D projects. Last but not least, enterprises have to work out a feasible vision about how to implement China Manufacturing 2025, the national roadmap towards being the world-leading manufacturing power. This national strategy can only be realized when all stakeholders from top to bottom have a clear idea about their own roles in translating the vision on paper into action.