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Nonviable “zombie” firms have become a key concern in China. Using novel firm-level industrial survey data, this paper illustrates the central role of zombies and their strong linkages with stateowned enterprises (SOEs) in contributing to debt vulnerabilities and low productivity. As a group, zombie firms and SOEs account for an outsized share of corporate debt, contribute to much of the rise in debt, and face weak fundamentals. Empirical results also show that resolving these weak firms can generate significant gains of 0.7–1.2 percentage points in long-term growth per year. These results also shed light on the ongoing government strategy to tackle these issues by evaluating the effects of different restructuring options. In particular, deleveraging, reducing government subsidies, as well as operational restructuring through divestment and reducing redundancy have significant benefits in restoring corporate performance for zombie firms.

From a dataset of Chinese firms in the 2005-07 period, we find that government investment boosted the performance of zombie firms and crowded out the growth of private firms; and that the higher the concentration of state banks, and of SOEs, the more conducive is the environment for nurturing zombie firms. With the exit of zombie firms, (a) the industrial output growth rate would be higher by 2.12 percentage points, (b) the capital accumulation rate by 1.4 percentage points, (c) the employment growth rate by 0.84 percentage points, and (d) the rate total factor productivity growth by 1.06 percentage point. Our results support a radical change in the way that government investment has been carried out, and support comprehensive reform of the state sector, but they do not necessarily argue against government investment in large infrastructure projects and strategically-critical areas.