Bankruptcies to Keep Rising As China Tackles Overcapacity

Chinese bankruptcies are likely to continue to rise sharply as the authorities become more accepting of them and tighter financial regulations take effect, but market forces are still playing only a minor role in determining failures in the state-owned sector, says Fitch Ratings.

There is little evidence yet that the government is willing to tolerate the job losses and the drag on economic growth that would accompany the bankruptcy of large "zombie" enterprises, which are responsible for the most significant corporate inefficiencies and account for the bulk of overcapacity.

The number of Chinese insolvency cases rose to 5,665 in 2016 from 3,684 in 2015, and is on track for another large increase in 2017, with 4,700 case filed in January-July alone, according to data from the Supreme People's Court. Cases resolved are also rising, reaching 3,602 in 2016 - up by 43% from 2015 - and 1,923 in January-July 2017.

The increase in insolvencies is partly policy-driven. China's authorities have become more accepting of bankruptcies in recent years, including in the state sector, and have made efforts to improve the insolvency framework. Allowing market forces to play a greater role in determining bankruptcies should, over the long run, reduce moral hazard.

Meanwhile, resolution of zombie enterprises - those that incur recurring losses and rely on the support of the government and state banks to survive - would be a step towards improving corporate efficiency and addressing overcapacity.

Bankruptcies remain infrequent

However, bankruptcies remain infrequent compared with other large economies. This will not change quickly. Moreover, few companies in the sectors most in need of restructuring have gone the bankruptcy route.

Only 12% of bankruptcies so far in 2017 involved companies in the highly indebted state sector; only 10% were from the real-estate sector, where the National Academy of Development and Strategy has classified 45% of companies as zombies; and only 2% were in the steel sector, where over half of companies are considered zombies and overcapacity is a significant problem.

These figures contrast to some degree with official comments that have associated bankruptcies closely with supply-side reform. Premier Li Keqiang reiterated at the National People's Congress in March 2017 that market-based measures to promote restructuring and insolvency settlement are a key component of the state's strategy to deal with zombie enterprises.

Meanwhile, the State-owned Assets Supervision and Administration Commission has drawn up a list of 2,041 zombie enterprises, mostly subsidiaries of central SOEs, and plans to resolve 345 of them in 2016-18.

The authorities may continue to favor mergers of weak companies with stronger ones as a less disruptive alternative to outright bankruptcy for large enterprises, given that maintaining high and stable economic growth remains a primary policy target.

Local governments are also likely to continue supporting troubled enterprises that are sizable employers in their localities.

SOEs employ over 60 million workers, but more than a quarter of them are unprofitable, based on official data. A concerted effort to wrap up non-viable companies would therefore almost certainly involve large-scale layoffs - the last major SOE reforms resulted in around 29 million job losses in 1997-2000. Layoffs of that scale are politically unpalatable, particularly because it may be difficult to absorb the affected workers into the industries of China's new economy. Sizable bankruptcies would also add to asset-quality issues at banks.

Bankruptcies are likely to continue rising quickly over the next few years in light of rising policy attention and the tightening of credit conditions since late 2016. The recent deceleration in credit growth also suggests firms will face slower growth next year, as reflected in Fitch's 2018 GDP growth forecast of 6.3% compared with the 2017 forecast of 6.7%.