According to UBS, the steel sector is running at 67 per cent of capacity, while coal is at 65.8 per cent. Further declines in utilisation can be expected as the economy cools further.

New research by UBS indicates that a 10 per cent capacity reduction will be needed across six core industries to help bring supply and demand into closer alignment. These excess capacity sectors include coal, steel, cement, flat glass, aluminium smelting and ship building. The cuts will trim 3.5 million jobs, according to UBS Economist Tao Wang.

“Two million direct jobs are expected to be cut in the excess capacity six sectors,” Wang said. “In addition, another 1.5 million workers may lose their jobs in other related sectors.”

Wang estimated that the resulting factory shutdown could boost the unemployment rate in China’s non-farm sectors by 0.5 to 0.6 percentage point.

“The government will likely provide compensation to some of the directly affected workers, partly through the central government’s special fund,” Wang said in a report.

Liao Qun, chief economist at Citic Bank International in Hong Kong, agreed, saying the biggest concern is massive job losses, particularly in less developed regions.

Many so called zombie companies have their industrial operations located in less-developed areas such as Shanxi, Hebei, Shaanxi provinces and Inner Mongolia, where laid off workers find it difficult to pick up alternative employment.

Wang said that the anticipated job losses would amount to a softer blow than the last major round of layoffs in the late 1990s, when more than 30 million jobs were cut in the state and collective sectors. In addition, the government will provide social benefits to laid-off workers by tapping a 100 billion yuan (HK$120 billion) fund, Wang said. The fund is designed to provide assistance to local governments as well as state-owned companies in doling out severance benefits to laid off workers.

Apart from layoffs, non-performing loans are another concern, however one that’s less easy to forecast as the blast wave of job cuts works its way through the economy.

UBS estimates total liabilities of the six major sectors glutted with excess capacity at 10 trillion yuan in 2015, of which 8.7 trillion yuan was debt. The coal and steel sectors together had a total of 7 trillion yuan in debts, of which about 4 trillion yuan were in bank loans, with the remainder in bonds and shadow credit.

“A 10 per cent capacity reduction will likely have a disproportionally bigger impact on bad debt,” said UBS strategist Wenjie Lu. “If companies that make heavy losses are closed, their bank loans will no longer be ever-greened and their debt can no longer be refinanced through bonds or other shadow credit, which means all the debt will effectively become ‘bad.’”

Liao from Citic Bank International said he wasn’t impressed with the plans put forward by the government of having banks exchange outstanding loans for stakes in companies.

The policy known as a “debt for equity swap” cannot fundamentally solve the problem of excess capacity, Liao said.

“The better way to relieve non-performing risk is for government itself to take on the debt rather than banks,” Liao said. The ratio of Chinese government debt to GDP is about 40 per cent, lower than many countries, according to Chinese authorities. “There is no big risk even if the ratio increases to 50 per cent from current 40 per cent,” said Liao, “but it could solve many problems in terms of excess capacity reduction.”

UBS Economist Ning Zhang estimates that a 10 per cent reduction in capacity at the steelmaking and coal mining sectors would lead to a 0.5 percentage point reduction in China’s GDP growth.

Liao agreed that in the short term excess capacity reduction will slow economic growth, but longer term it would be beneficial to the Chinese economy. Surviving companies will enjoy profit margins once the field of competitors has been culled, Liao said.

“When the companies with lower utilisation rates or with big losses are closed, other productive plants will be incentivised to produce more and increase their utilisation rate eventually,” UBS’ Zhang said.

Zhang said fixed-asset investment in China may slow following the capacity reduction because of strict restrictions on new investment.

“Assuming fixed-asset investment in the excess capacity sectors decline by 50 per cent from the current levels, it could lead to one percentage point decline in overall FAI growth.”

The slower FAI and consumption growth may have further downward impact on GDP growth down the line, he added.