Along with a number of other government agencies, China’s central bank has issued what is hoped to be the long-awaited death knell for the country’s growing number of unprofitable – or “zombie” – companies. Local governments and state-owned asset management groups now have three months to submit a list of zombie firms, with a mandate to restructure them if possible or dispose of them if necessary.

The move shows that mounting corporate debt, issues with overcapacity, and widespread environmental degradation wrought by China’s zombie firms is still firmly on Beijing’s agenda. Even so, while the cull is no doubt welcome news for many keen on national market reform, policymakers need to avoid the mistakes of the past, where anti-zombie measures disproportionately affected smaller, private firms. However, the truly problematic thorns in the country’s industrial side,  state-owned enterprises (SOEs) in heavy industries such as steel and aluminum, are likely to emerge from the crackdown relatively unscathed.

Every time China pushes for consolidating the corporate landscape the country faces a dilemma: an economic transition away from exports and industrial production cannot be avoided if environmental protection and curbing overproduction really is a priority. But the specter of unemployment and subsequent threats to social stability as well as economic growth can hardly be tolerated in the process.

Previous efforts akin to this month’s and the inevitable surge in bankruptcies of unprofitable firms have indeed led to improvements in consolation. After a round of tightened financial regulations implemented last year, the official number of insolvency cases rose from 3,684 in 2015 to more than 4,700 in the first seven months of 2017. Still, only a small number stem from the primary target sectors, namely steel and aluminum. Steel, for example, accounted for just 2% of the total number of insolvencies, although the sector is stricken with so much overcapacity that more than half of its firms were marked with zombie status.

These numbers reflect a major problem in the zombie hunts: they typically neglect the SOEs they should truly be targeting. Instead, most of the firms liquidated in last year’s cull were in the private sector and relatively small. China still uses up 6.5 units of capital to create one unit of GDP growth, a ratio double that of a decade ago. This reflects a persistent problem with reckless and unsustainable credit expansion. The state’s “undead” companies, made up of more than 2,041 massive firms with assets exceeding $450 billion, have so far always lived to die another day.

The state’s “undead” companies, made up of more than 2,041 massive firms with assets exceeding $450 billion, have so far always lived to die another day

China’s de-zombification forms a focal part of Beijing’s envisioned economic shift to more sustainable growth in the long term, but this shift has been slow to occur. Overcapacity has actually worsened since 2009 amid another hefty influx of fresh credits. Between 2010 and 2015, China Iron and Steel Association data revealed that overcapacity had reached a whopping 30%, with major firms sitting on debt ratios of around 70%. This is due to the fact that SOEs in heavy industrial production sectors, such as steel and aluminum, are still vital organs in the current economic model.

To make matters worse, the central government’s order to local and regional authorities to stop subsidizing unprofitable metals plants has been falling on deaf ears, and has contributed to an annual capacity surplus of around 400 million tonnes. According to the Wall Street Journal, this support covers billions in cash assistance and subsidized electricity. Recipients range from aluminum and steelmakers to coal miners and solar-panel producers. Trade partners, in the meantime, have been forced to launch anti-dumping investigations amid the onslaught of cheap Chinese metals, particularly from the United States.

Ironically, the torrid international trade environment is only perpetuating the SOE life-support. US President Donald Trump is boasting that placing tariffs on Chinese steel and aluminum imports is forcing China to return to the negotiation table and abandon unfair trade practices. But in reality, the US tariff system is so deeply flawed that Chinese companies like Ta Chen International are able to secure exemptions and this way import up to 1 billion pounds of aluminum into the US. Not surprisingly, president and CEO of the Aluminium Association Heidi Brock has urged the US Commerce Department to overhaul the exemptions request system so as to ensure that the threat from Chinese exports to the domestic industry is mitigated.

Local officials push back

At the same time back in China, local officials have begun to push back against measures that would otherwise justify the closure of local plants. Despite Beijing’s insistent calls for overcapacity reduction and environmental protection, the freedom of local officials to implement production cuts often means that they often don’t. After the Ministry of Environment and Ecology allowed local authorities to fine-tune emissions reduction measures according to regional levels, inspectors charged regional departments with lacking the willpower to constrain industrial growth as necessary.

Their reluctance to let go of local manufacturing capacity is understandable. The culling of SOEs carries the very real risk of exacerbating unemployment levels and social instability, especially while the US-China trade war is a drag on economic growth. The fact remains that SOEs are a symbol of China’s industrial success and a backbone of the communities that have grown to depend on them.

Last year’s attempt to reign in the gluttonous coal industry saw industries grind to a halt and the proliferation of online stories about schoolchildren battling frostbite. Struggling to find the right balance, local governments are on the frontlines of what looks to be an unwinnable battle of expectations. But as long as the authorities are unwilling to make earnest – though no doubt painful – decisions to rein in the entirety of the country’s zombie horde, China’s battle with corporate debt, economic overcapacity and rampant pollution will continue.