Faculty of law blogs / UNIVERSITY OF OXFORD

How Specialized Courts Changed the Chinese Bankruptcy System

Author(s)

Bo Li
Jacopo Ponticelli

Posted

Time to read

2 Minutes

In the last decade, China experienced a massive increase in corporate debt. Academics and policy makers have raised concerns about the risks associated with the Chinese credit boom and the recent growth in the number of bankruptcy cases. Despite the increasing pressure on the Chinese insolvency resolution system, little is still known about how bankruptcy works in China and the role played by the government in this process.

In a new working paper, we shed some light on how firms go bankrupt in China using newly available case-level data. Two main changes in bankruptcy regulation occurred in China in the last decade: the reform of the bankruptcy code in 2007, and the introduction of specialized courts between 2007 and 2017. Until the introduction of specialized courts, bankruptcy cases in China were filed in local civil courts. Similar to other developing countries, Chinese civil courts are characterized by limited expertise in bankruptcy resolution and long delays in processing cases. In addition, Chinese local civil courts tend to operate under the influence of local governments. In particular, local politicians have strong incentives to keep financially distressed state-owned companies alive to contain local unemployment, an important determinant of their political career. Thus, even after the 2007 reform has aligned Chinese bankruptcy law to those in the US and Europe, the influence of local governments over courts has traditionally prevented a timely resolution of state-owned ‘zombie’ firms in financial distress.

Recently, the central government has expressed concerns about the large number of ‘zombie’ firms operating in China, and recognized the lack of efficient bankruptcy procedures that could facilitate their liquidation or restructuring. Following a 2014 recommendation by the Supreme Court, several Chinese provinces started introducing new courts specialized in bankruptcy. These specialized courts are modeled on US bankruptcy courts and run by insolvency professionals, with the objective to decrease the influence of local politicians on the judicial system and quicken the liquidation of inefficient state-owned firms in an economy already characterized by high debt levels.

In our empirical analysis we exploit the staggered introduction of specialized courts across Chinese provinces to study their effect on bankruptcy resolution outcomes and corporate credit markets. Our findings indicate that the introduction of specialized courts led to an increase in the share of liquidations of state-owned firms at province-level. We also find that cases filed in provinces that established specialized courts have lower resolution time compared with those filed in provinces where civil courts still handle bankruptcies. This result is driven by a decrease in the time to resolve insolvency of state-owned firms, while we find no effect on time in court to resolve insolvency of privately-owned firms.

We also study the implications of new courts on credit markets. Overall, our results suggest that, on average, the introduction of specialized courts did not affect the size of new bank loans or the probability of getting a new loan for Chinese companies. However, there are significant heterogeneous effects between state-owned and privately-owned firms. In particular, following the introduction of specialized courts, state-owned firms experienced a decrease in size of new bank loans and had lower probability of obtaining a new loan. On the other hand, our evidence suggests privately-owned firms benefited from the introduction of new courts in terms of access to bank lending.

Overall, the data suggests that the introduction of specialized courts in China favored the transition from a state-oriented to a market-based bankruptcy regime, at least when it comes to local government influence on insolvency resolution of local state-owned firms. New courts brought faster resolution of financially distressed state-owned firms and pushed local private firms to invest more, thus potentially mitigating resource misallocation in Chinese credit markets.

Bo Li is an Assistant Professor at PBC School of Finance, Tsinghua University.

Jacopo Ponticelli is an Associate Professor of Finance at Kellogg School of Management, Northwestern University.

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