China's economy is being held hostage.

The so-called zombie companies the Chinese government is supposed to be reforming have hijacked the government's economic policy, and the dangerous bubble forming inside the country stands to grow until this hostage situation has ended.

The zombies are state-owned enterprises mostly in the property, commodity, and industrial sectors. They are carrying a ton of debt, and this year they have started defaulting on that debt for the first time.

"SOEs are truly the elephant in the room of China's debt problem," Societe Generale analyst Wei Yao wrote in a recent note. "They are the biggest borrowers and underperformers, but SOEs have been shielded by implicit government guarantees until only very recently. This is now beginning to be recognized and addressed."

Or is it?

According to The Wall Street Journal, behind closed doors the Chinese government has been going back on a promise it made to the world — that it would allow its currency, the yuan, to float freely with the market. It is just one example of how the SOEs, and the powerful government agency representing them, have been able to influence policy and take the country off the path to reform.

Free the yuan

The promise to depeg the yuan from the dollar was a promise China made to be allowed to enter the Special Drawing Rights basket, an elite club of special reserve currencies designated by the World Bank. It was admitted to the club in November, and by December it said it had pegged the yuan to a basket of currencies instead of to the dollar.

That doesn't jibe with this recent Journal report, which said documents show that China's leaders gave up on letting the yuan float freely after the country slightly devalued the currency back in August. At that point, President Xi Jinping became more obsessed with keeping the economy stable than with going through the painful process of reforming it.

So the yuan is being pegged to the dollar in part to stop money from leaving the country but also in part to help the SOEs, who have a ton of dollar-denominated debt.

From The Journal:

The powerful State-Owned Assets Supervision and Administration Commission was instrumental in convincing Chinese leaders to backtrack. The more the yuan is allowed to weaken, officials said, the more expensive it will be for already struggling state firms to service their loans.

A 3% depreciation of the yuan could add $25.6 billion to Chinese companies' annual interest payments on dollar debts, according to estimates by analysts at BNP Paribas.

So who's really running the show here? A closer examination of China's foot-dragging on its promise of reform points, again, to the SOEs.