Zombie Firms and Soft Budget Constraints in the Chinese Stock Market*

The growth of zombie firms has caused increasing concern. The present study seeks to understand why zombie firms have been emerging in recent 10 years and to further explore the mechanisms of their formation. Based on a dataset of Chinese listed companies from 2012 to 2016 and empirical analysis, the present study ascribes the prevalence of zombie firms to soft budget constraints. After using a modified identification model in the Chinese context, we concluded that zombie firms have access to some external resources such as credit support from banks and governmental subsidies, substantiating soft budget constraints among zombie firms. To explain this phenomenon, further analysis reveals that zombie firms bear a heavier policy burden by hiring excess employees, which will bring them more subsidies and a stronger relationship with government in return. This result indicates that policy burden is the reason for soft budget constraints, which exacerbates the zombie firm problems in China.