Bankruptcy and a Shifting Focus

Published on Author Alden Schade

The Chinese government has long supported growth in heavy industry with subsidies and other incentives. But now, as the economy looks to balance towards a more diverse mix of industry and services, the government is doing more to aid the transition. Recently, a fund to spur growth in service-oriented businesses was established, and although a majority of the money came from foreign investors,
this is still a step in the right direction.

Graphs illustrating increase in corporate bankruptcy cases. Image Credit: Wall Street Journal

When Professor Murphree came and spoke, we heard about rising labor costs and the slowing pace of Chinese manufacturing. As the economy grows, workers are paid more and more, resulting in fewer opportunities for the labor arbitrage that helped China’s economy grow so quickly over the past three decades, growth that has recently contributed to global overcapacity in several heavy industries. The government, however, has begun to make greater use of one course of action that had not been used as frequently over the years: bankruptcy. In the past, government funds were used to support failing manufacturing businesses because the political costs of unemployment and layoffs were higher than the financial cost of supporting the companies. Now, however, an increase in bankruptcy cases shows that this model is losing popularity. In 2016, Chinese courts accepted 54% more bankruptcy cases than in 2015, with most resulting in liquidation, likely due to more companies taking on higher loads of debt. This rapid uptick in borrowing and bankruptcy is a pronounced change from past policy, a change that will likely grow in significance over the next few years. Many of the liquidated companies are so-called “zombie firms,” unprofitable manufacturers that have been kept operational by government money. The fact that these firms are losing support may indicate a broader policy shift.

Between increased foreign funding for service industries and bankruptcies reducing the workforce and production capacity of heavy industry, it seems that the government is beginning to pivot its goals for economic growth and look to new sectors to shoulder the burden. Only time will tell if reducing manufacturing employment through bankruptcy will be balanced by growth in other industries, or if this new policy will bring political opposition and unrest.

12 Responses to Bankruptcy and a Shifting Focus

  1. Alden, you raise good points. With so many “zombie firms” overcrowding the market the Chinese likely want to free up the market by continued liquidation. The question becomes whether this trend remains at a steady 5500 bankruptcies per year or, given the large number of firms in China, we see a continued trend of upticks in bankruptcy cases. Only time will tell, but I am sure Beijing is keeping a close eye on this.

  2. The uptick in bankruptcy reminds me of the Shadow markets Leland Miller spoke to us about a few weeks ago. Could this increase in bankrupt firm also be a signal of failing credit flows from these shadow firms who can no longer pay back the big banks because their lines of credit have fallen through? It would be interesting to analyze the causes of the bankrupt firms.

    • I think you’re right about the flows of credit between banks and manufacturers. It would be interesting to see if they are declaring bankruptcy due to defaults or for other reasons. This might be something to watch considering an increase in default rates can have a significant impact on credit markets.

  3. Its an an interesting case study and it draws into questions what this will do to the Chinese economy and its growth going forward. Between increase in bankruptcy and greater default rates, I would assume that this would further exacerbate the growth issues. It is also interesting to see the the shift away from ‘zombie firms’ and towards other sectors. I would assume that consumer products and commerce will begin to take over as a sector of dominance.

  4. More bankruptcy certainly signals more entry risk for entrepreneurs, but some increase in bankruptcies actually indicate a normalization of the industrial economy in China? The government policy of removing supports for insolvent businesses will certainly result in more failures, but it also raises the bar. Businesses will have to change their practices and take less risks (or simply move their risk around) to stay profitable. Corporate darwinists would argue this can improve the economy’s strength in the long run.

  5. Bankruptcy implication in China now could also be the Chinese accepting Western capitalistic practices. I agree with Mason as well that the amount of “zombie firms” means that options to liquidate must exist. Ryan’s point on the shadow market correlates with the bankruptcy topic as well, and I think this ultimately falls under a credit system framework that the Chinese need to firmly solidify.

  6. This will be interesting, as you discuss, if the Chinese economy slows down significantly as seems a distinct possibility given the figures we’ve discussed. It seems that China will be forced to deal with these “zombie firms” if it wants to combat a potential slow down, but seems unwilling to do so. As stated by a few others, if not fixed, this might result in a credit problem China will need to address.

  7. I agree that the continued presence of “zombie firms” reflect Beijing’s stability concerns. In recent years, we’ve seen how economic transitions and a decline in manufacturing can create political instability across the globe (Brexit, Trump, rise of populism in Europe). It seems to me that the propping up of these firms is an effort on the part of the Chinese government to kick the can down the road until they figure out how pivot their economy without creating significant political instability.

    • I think one of the other issues that China is “kicking” down the road is that of class conflict. China’s economic policies could be causing increasing wealth inequality down the road. The expansion and maturation of the manufacturing industry will be followed by a demand by Chinese for probably two things: a greater share in the new wealth in China, and a more democratic system. We have seen that as economies grow, people have more time on their hands to worry about greater issues like this.

  8. While others have brought up their worries surrounding these “zombie-firms”, I think that the increasing presence of these signals a positive shift in Chinese manufacturing and the economy as a whole. Bankruptcy is the natural selection of business — firms that are not fit to compete will go under, resulting in an overall more competitive and lean business environment. As you have said, I think that the Chinese government is realizing this and is no longer willing to support these failing businesses.

  9. It would be useful to have detail on what sorts of firms are using bankruptcy – are many really SOEs? In any case, 5500 is a very, very small number given the size of China’s economy.

    It does likely reflect a greater degree of formality in business, with contracts for money lent and assets that clearly belong to a company.

    In the past the central government has shut down hundreds (and likely thousands) of SOEs, particularly in 1994-95. In Shanghai alone that led about 1.5 million people to lose their jobs. But at that time strong growth meant they didn’t end up unemployed for long.

    My sense is that “zombie” firms are more likely to be controlled by local governments, not Beijing and not even provincial governments.

  10. I think we’ve discussed in class how increasing privatization in China has been accompanied by the development of a completely new financial culture, one which was nonexistent (and unnecessary) prior to the reform years. As Prof. Smitka mentions above, I think bankruptcy filings are indicative of increasing formalization of this sector, as conventions become more standardized and both firms and consumers establish standard patterns of financial behavior.