The Puzzle of Chinese Bankruptcy Law

The new Chinese Enterprise Bankruptcy Law 2006 has been written in accordance with the best international practice. We would therefore expect to see it being used to resolve most cases of corporate financial distress. However, the law is only rarely used in practice which prompts search for explanations and alternative mechanisms that the creditors rely on when trying to enforce their claims. In this paper I analyse this puzzle focusing in particular on debtors’ and creditors’ incentives for using extra-legal substitutes and formal law. Based on this analysis, I propose two major reasons for the law’s limited use, and explore three alternative enforcement mechanisms that have been used instead of the formal law. I argue that the main reason for low use of the new law is that in practice it produces low payoffs: private creditors don’t use bankruptcy procedures because they produce low financial payoffs, and that the government- controlled players (state-owned enterprises, state banks, etc.) are not allowed and/or willing to rely on bankruptcy procedures because they disregard the socio-political interests. Instead, the players in bankruptcy rely on extra-legal alternatives which provide higher payoffs. Private creditors rely on the reputation mechanism to enforce repayment, and the government uses various forms of bailouts and financial support for the ailing state enterprises. In companies with a mixed public-private ownership, hybrid solutions are adopted to satisfy the interests of both groups