As debt defaults for state-owned enterprises in China rise, international investors find themselves in what for most is a new place: Chinese bankruptcy courts. That may be just the right venue for them, debtors and regulators to meet and take a crucial step toward a better functioning economy.
Investors have been spending years to recover their money out of court, but China’s bankruptcy law has now gained enough critical mass to test in modern markets. First trialed in 1986, it’s been expanded and updated in the years since then, including a new section in 2007 that deals with reorganization of companies, modeled on the famous US Chapter 11. By the end of 2017, almost 100 courts dealing with bankruptcy and liquidation issues had been set up.
That turns out to have been well-timed for the gradual slowdown that morphed into crisis this year as Covid-19 took a grip on the economy, crushing some businesses along the way. Gezhi Automobile Technology Co., a creditor of Brilliance Auto Group Holding Co., filed an application last month to start a court-led restructuring after the joint-venture partner of BMW AG defaulted on almost $1 billion of debt. The tribunal has approved the petition.
Other large, state-backed companies have met a similar fate. Earlier this year, creditors filed for the reorganization of Peking University Founder Group Co., a commercial arm of Peking University involved in information technology, healthcare, real estate and finance. At one point, the group owed as much as 112 billion yuan ($16 billion) to 400 financial institutions. The court accepted the petition in five days and appointed administrators; the reorganization process is ongoing. The same kind of fairly rapid program is playing out elsewhere.
Investors should wonder why this relative rush is happening now. Neither the law nor Chinese companies going belly-up is a recent phenomenon. One of the answers is that now the court infrastructure is in place, Beijing is using systematic workouts to separate the dead from the living. This amounts to attempting reform of the bloated state-led corporate system from a different angle.
Large state-backed enterprises were long considered essential for the Chinese economy, in theory helping implement the government’s industrial policies. They were given favorable access to credit for their services. Over time, balance sheets became heavily leveraged, inefficiencies rose, and returns on assets fell. Much of this came to the detriment of private companies, which crowded out of the credit markets. Beijing has made attempts to reform the thousands of state-led firms at the central and provincial level, such as through mixed ownership and supply-side changes, but they remain a drag.
Using the bankruptcy law and judicial system is a clear indication that the government is looking to liquidate or restructure encumbered enterprises. How much is recovered is of less concern than forcing efficiency in the state-led corporate system. Meanwhile, breaking up vested local government interests, which are tightly connected with such firms, could help better allocate resources. That should lead to a more efficient flow of credit, blunting a trend where each yuan has been doing less for economic growth.
From Kenya to India, countries globally are looking to strengthen bankruptcy regimes and creditors’ rights and stop their economies choking on long insolvency delays and litigation. Speeding up the process is the key to success.
China has been moving faster than before, but most cases end up taking almost two years. Founder Group creditors approved a restructuring plan last month, fast by local standards. In the US, Chapter 11 reorganization and liquidation are quicker, sometimes done overnight via pre-packaged deals. There, debtors typically propose a plan to keep things going and pay out creditors over time. Under China’s law, it’s unsecured creditors — not banks that hold collateral of the failing company — who push the bankruptcy procedures in court. Sorting through their issues typically takes longer.
A study in July found that the special courts have been increasingly effective for bankruptcies at state-backed firms, with the average duration cut by 85%, or 506 days. At city level, this has led to improved productivity for the survivors “and a decline in the labor share in industries characterized by higher presence of zombie firms.”
With privately owned borrowers, investors have veered toward consensual settlements, making for an erratic resolution of defaults. These companies have gone under in larger numbers because they didn’t always have an implicit state guarantee or easy access to capital. Court-led processes aren’t focused on the sale price of liquidated assets. This motivates creditors to seek out-of-court settlements to maximize recovery, according to S&P Global Ratings.
The Chapter 11-style bankruptcy process is an efficient way to reorganize a company and maximize enterprise value. It’s not always a perfect solution, and success can come down to a business wanting to reinvent itself. But it offers a clear and predictable path to restructuring and cleaning house. China knows it can no longer afford to prop up zombie firms. If Beijing can pull off bankruptcy better, it will rebuild the credit market credibility it needs.
Bloomberg
