In a recent executive meeting of the State Council, Chinese Premier Li Keqiang reiterated that reforming "zombie enterprises" needs to be hastened through mergers, reorganizations or withdrawal from business. This is the third time this year Li has emphasized the urgency of dealing with such enterprises, which is part of China's efforts to improve the overall efficiency of state-owned enterprises (SOEs).

The so-called "zombie enterprises" refer to SOEs that have been unprofitable for an extended period of time but survived with support from lenders and the government. Their existence has become a drag on the economy.

To start with, these enterprises have privileged access to funding, staunching the market-oriented allocation of financial resources. A large amount of funding goes to the property sector, local governments and these "zombie enterprises," making it difficult and expensive for small and micro businesses to get the money they need. Giving capital to poorly run businesses gives rise to more debts, higher costs, slower capital velocity and lower profitability in the rest of society. Local governments have less income because the "zombie SOEs" take up financial resources and fail to create additional wealth, making it harder for governments to roll out tax cuts for businesses.

Second, some SOEs continue to borrow money from banks to pay off old debts, becoming mired in a vicious cycle of experiencing difficulty in managing the business and seeking additional capital. Wasting these loans on "zombie SOEs" has increased non-performing loans (NPLs) at banks. Recent financial filings from 16 listed banks said their NPLs have been on the rise for nine consecutive months, partly caused by an increase in the number of "zombie SOEs."

Third, "zombie enterprises" are a huge burden to the economy at large. Local governments have to look after the SOEs' interests when encouraging companies to merge, reorganize, upgrade industrial structure and innovate. This undermines the viability and consistency of implementing policies and makes some reform measures impossible to enact.

Finally, these enterprises' inability to pay off their debts makes them a major source of credit default. Other companies may follow suit, deteriorating China's credit environment and adding additional difficulties to the country's economic restructuring.

With these enterprises causing such harm, why haven't they been eliminated from the economy? The main reason is they have intertwined interests with local governments.

Local governments continue to give "zombie enterprises" assistance because government officials' performance is based on GDP, which would be heavily impacted by businesses declaring bankruptcy or going under reorganization. Officials are reluctant to let the SOEs go out of business to create the illusion of stable economic growth and tax income so that they can get promotions.

Fear that massive layoffs at SOEs following their bankruptcy would cause social instability also keeps local governments rescuing them. Some SOEs' top priority is to keep jobs, not to make money. Local governments continue to provide funding and policy support to the SOEs despite their poor business performance.

And some governments and SOEs are taking a gamble, betting that the businesses will survive the economic slowdown. Under this illusion, "zombie SOEs" turn to the government for help. Some banks follow tacit government endorsement, believing there is little risk, and continue to fund these enterprises.

To further complicate matters, a portion of the public sympathizes with these "zombie enterprises" and is unwilling to accept their failure, standing in the way of their elimination.

To promote sound economic growth, the government must decide to completely weed out these non-performing businesses. Allowing them to declare bankruptcy and reorganize will both increase the overall efficiency of state assets and SOEs and stop banks' NPL ratio from rising. In the meantime, their bankruptcy would serve as a warning to other businesses. If the government can refrain from intervening in business operations and let the market allocate its resources, society will see that birth, development and death of businesses are a normal process.

Three things need to happen before "zombie enterprises" can go out of business. First, an exit mechanism for "zombie enterprises" concerning their bankruptcy and elimination should be formulated to offer legal guarantees for their closure. Second, a risk prevention system should be established to better prepare financial institutions for dealing with bankruptcy of "zombie enterprises" and avoid systematic financial risks. Finally, the social insurance system needs to improve to help laid-off workers be resettled and trained for new employment opportunities, and to offer the necessary social relief and aid to those who are unable to work. This will ensure a soft landing and avert social unrest after "zombie enterprises" go bankrupt.

This is an edited excerpt written by Mo Kaiwei, a research fellow with China Academy of Regional Finance, published in Securities Times 

Comments to yushujun@bjreview.com