How do zombie firms affect China's industrial upgrading?

Industrial upgrading to create a new growth engine for China's economic development is crucial. Using data from the Chinese Annual Survey of Industrial Firms, we demonstrate that zombie firms have hindered industrial upgrading in China. We employ the Bartik method to construct instrumental variable to control for endogeneity, and find that when the proportion of an industry's zombie firm assets increases by 1%, the level of industrial upgrading reduces by approximately 0.85%. Two mechanisms are identified. The first is resource mismatch at the industry and firm levels. The second is the suppression of innovation effects. Study results demonstrate why China's industrial upgrading is weak from the perspective of firm structure. Our findings suggest that the government should make better use of market-oriented policies and the "creative destruction" mechanism to deal with zombie firms, in order to promote industrial upgrading.