Throwing good money after bad: Zombie lending and the supply chain contagion of firm exit

Abstract

This paper studies whether the bailout of downstream firms helps stop the supply chain propagation of business failure. By analyzing persistent zombie lending in China, we show that such a bailout policy does not work. Zombie lending to downstream firms does not reduce the exit likelihood of upstream firms. Worse, it distorts efficiency-based firm exit in upstream industries. The exit distortion effect works through the trade credit chain and is more profound in industries with stricter financial constraints and tighter supply chain connections. Our findings reveal the importance of credit allocation efficiency for the Schumpeterian process of creative destruction that is essential for economic growth.