China’s Zombie Firms Threaten Growth: Rising Debt, SOE Risks & Reform Imperatives

The recent Dallas Fed article gives a detailed picture of growing “zombie lending” in China: prolonged overinvestment, weak profitability, and widespread roll-overs of unprofitable corporate debt. Notably, while China’s nonfinancial private sector credit exploded through 2008-2016 (from ~106% to ~188% of GDP), the trend in debt has only slowed—not reversed—with total debt exceeding 300% of GDP by June 2025. This raises acute risks for financial stability and economic productivity.

Zombie firms—corporate entities that can’t cover interest payments from operating profits—are now holding a significant portion of assets in key sectors. Between 2018 and 2024 the overall share of such zombie assets among non-financial firms climbed from 5% to 16%; real estate zombies now account for ~40% of assets, services ~17%, and manufacturing ~11%. These share jumps exacerbate China’s property sector crisis and signal broader contagion into non-SOE and non-tradable sectors.

The cost is manifest: zombie firms distort resource allocation—financing, capital, labor—crowding out healthier firms, stifling investment, and dragging on productivity. Empirical studies show that in areas with intense bank competition, for example, lower credit standards enable even opaque and unstable firms to access cheap credit, increasing their zombification likelihood. Excessive debt burdens also reduce fixed asset investment in normal firms, especially non-SOEs and smaller taxpayers, as capital is diverted to maintain the unsustainable operations of zombies.

The social and structural consequences extend beyond finance. Zombie firms reduce the attractiveness of cities to new labor, especially among younger and low-skilled workers; industrial structure becomes rigid, new firms face barriers to entry; and environmental pollution rises due to overcapacity and inefficient operations in zombies, especially in heavy and real-estate related industries. These effects make China’s ongoing rebalancing toward consumption-and-services growth more difficult.

From a policy and strategic perspective, China faces a delicate balancing act. On one hand, allowing zombie firms to fail or be restructured accelerates economic adjustment and could unlock latent productivity. On the other, sudden exit could undermine social stability, debt markets and local government balance sheets, especially given the high real estate and SOE exposure. Banking reforms—capital provisioning, credit discipline, forced recognition of non-performing loans—are required but must proceed carefully. Reforming SOEs and perhaps privatization where feasible may help; recent NBER work suggests privatizing zombie SOEs delivers outsized improvements in productivity, profits, leverage and subsidies relative to healthy SOEs.

Open questions remain over how resilient China’s banking system is to large scale recognition of zombie exposures; what the fiscal costs of cleanup and job displacement will be; how local governments will respond given their stake in real estate and SOE performance; and whether policy incentives (e.g. subsidies, state bank forbearance) will continue to support zombies implicitly despite stated intent to reduce them.