Bankruptcy & Insovency

For China's program of economic reform, which sees the country opening its doors to the outside world, its newly passed bankruptcy law has twofold significance: to boost its credit market as it gives full access to foreign lenders, and to deal a final blow to the "iron rice bowl" employment system at its state-owned enterprises (SOEs).

Following its commitment to accession to the World Trade Organization (WTO), China will fully open its banking sector at the

end of this year to foreign lenders, which will then compete with their Chinese rivals on an equal footing. This will no doubt boost the development of China's credit market. But such development requires a legal basis, and that is where the new bankruptcy law comes into play.

The law, to be effective from June 1, 2007, gives creditors' claims top priority when the debtors undertake the process of liquidation, which is more in line with the international practice. This would certainly give foreign banks some legal assurance when issuing yuan loans, particularly to SOEs.

In contrast, under the current regulation governing the bankruptcy of SOEs, workers' interests would be given top priority. In other words, when an SOE goes under, its assets, even those pledged for loans, are to be used to pay workers' salaries and other benefits first, while the creditors can only get what would be left. Such protectiveness of workers' interests reflects Beijing's deep concern with possible social unrest caused by laying off SOE workers. But under such circumstances, it is very unlikely that foreign lenders would be willing to grant loans, even with guarantees.

In this sense, the law should also help boost China's market-economy status, which is still not recognized by its major trade partners such as the United States and the European Union.

"The successful enactment of the law could significantly improve China's profile in the WTO, since the law will eliminate some concerns of foreign investors by establishing a legal framework and market environment with credibility, efficiency, assurance and expectation," said Li Shuguang, one of the drafters of the law and a professor at Beijing's China University of Political Science and Law.

Executives of domestic lenders, particularly the four big state-owned banks - the Industrial and Commercial Bank of China, Bank of China, China Construction Bank and the Agricultural Bank of China - will also applaud the new law. The banks have had to dispatch "policy loans" on government orders to SOEs, and they suffer badly when their debtors become bankrupt.

The four banks bear a crushing burden of bad loans that threatens the stability of the institutions and China's financial system. The government has injected huge amounts of capital to help them lower their non-performing-loan (NPL) ratio ahead of opening the sector to foreign competitors. With government help, Chinese banks' NPL ratio shrank by 4.2 percentage points by the end of 2005 to 8.6%, according to the China Banking Regulatory Commission.

One of the major purposes of the current bankruptcy law, which was enacted in 1986, is to rescue and improve the management of SOEs, not to let them go out of business. How to readjust debtor-creditor relations in the process of liquidation was not on the decision-makers' agenda. Therefore, bank creditors can often only recover from the "bankrupt" SOEs 3-10% of the book value of their loan.

Xie Ping, general manager of the Central Huijin Investment Co, the central government's investment arm, which holds majority stakes in three of the big four banks, has long criticized the lack of a real bankruptcy law to protect creditors. "A good bankruptcy law can establish effective market constraints, push enterprises to improve governance, and stick to the principle of paying off obligations, as well as protecting the creditors' and debtors' rights."

Nowadays in China, most of the collateral creditors are banks. Because the banks' claims are given a low priority, they became excessively cautious in lending, resulting in a credit crunch on mid-sized and small enterprises.

From this viewpoint, the new bankruptcy law is expected to help boost China's credit market. In this sense, it will also likely help foster the social value of respecting credit, which is lacking in traditional Chinese culture.

The new law will apply to all sorts of companies, including listed and non-listed companies, domestic and foreign companies, privately run or state-owned, as well as financial institutions.

The law epitomizes the gradual nature of China's market-oriented economic reform, which has largely centered on figuring out a viable way to close down insolvent SOEs.

In theory, the current bankruptcy law also acknowledges that claims in liquidation should be given priority. In practice, however, the priority has in effect been subordinated by the so-called "policy bankruptcy", or bankruptcy ordered and administered by the government, which trumps the protection of creditors. The State Council stipulated in 1994 that even land owned by an SOE pledged for loans can be used to pay off laid-off workers.

Since 1994, under the "policy bankruptcy", all assets of the bankrupt SOEs, including guarantees and collaterals, have been literally used up to pay laid-off workers. Sometimes the government subsidizes the bankruptcy if the assets are not enough to cover such obligations. Along the way, the government has been arranging the market exit of exhausted mining companies and big and middle-sized SOEs under "severe difficulties". So far, two-thirds of such SOEs have been closed down and 7.19 million workers laid off and "settled" by governments at various levels. In coastal regions, most SOEs that need to go out of business have made such deals.

At present, courts must get permits from the government before triggering the bankruptcy process. The new law ushers in the professional "bankruptcy manager" system in line with international business practice. Some analysts liken the reorganization practice to that under Chapter 11 of United States Bankruptcy Code.

Nevertheless, the new law is still a compromise between implementing an international standard and concern over social unrest. Therefore, an additional 2,116 SOEs already lining up for "policy bankruptcy" will be allowed to enjoy the "Last Supper" until 2008, exempted from the new law. The State Council has this year set aside 33.8 billion yuan to help these SOEs settle with their laid-off workers, which could number up to 3.51 million.

Under some "special circumstances", the priority will be given to workers' obligations. The "caveat" addresses the interests of marginalized people during the transition to a free-market economy.

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