As a transitional economy, China is struggling to strike a balance between government and legal forces in determining corporate bankruptcies.

In a mature market economy, the court, creditors and bankrupt companies are generally involved in bankruptcy cases. The situation is different in China. Its largely exclusive State-owned enterprises seldom claim bankruptcy and the government still plays a role in the matter as the country undergoes its transition to the market economy.

But now, as the market develops, the government is intending to bow out from such cases.

The country's State asset administration leaders have on various occasions said the government will stop bailing out failing State-owned companies after 2008 and require them to apply for bankruptcy based on market rules.

For the next four years, the State will remain the savior of insolvent State companies with so-called "policy-oriented bankruptcies," according to a national corporate closure and bankruptcy blueprint approved by the State Council in February.

The transition will cost the State coffers dear, but it is nonetheless a crucial step in the country's market-oriented reforms.

In market-oriented bankruptcy procedures, the cleared assets of the company going down are first used to re-pay creditors, while priority is given to arrangements for unemployed workers in the "policy-oriented" cases.

In the case of "policy-oriented" bankruptcy, mortgaged assets as well as cleared assets are used to compensate workers after the firm goes bankrupt, and this is clearly against market rules.

On the other hand, the low salary arrangement inherited from the old planned economy and the current porous social security network make it necessary to grant preferential treatment to workers of bankrupt State firms. It is not only an economic issue - it also has social implications.

The obvious contradiction arises from the transitional economic system and this is inevitable if the State wants to cut the Gordian knot. If the State does not take this step, the law will always be mixed up with administrative forces in bankruptcy cases.

Between 1994 and 2004, 3,484 State companies went bankrupt, with 237 billion yuan (US$28.5 billion) in loans written off by State-controlled banks. The government made arrangements for 6.7 million unemployed workers, according to Shao Ning, vice-minister of the State Council's State Assets Regulatory and Management Commission.

The national blueprint lists another 1,828 State enterprises waiting for bankruptcy approval, which would involve losses of 122.1 billion yuan (US$14.7 billion) and settlement for 2.81 million workers.

Those enterprises are mainly in larger industries, especially in China's northeastern rust belt and less-developed inland areas.

After 2008, the State will withdraw from bankruptcy procedures, a practice that should be put under the control of market.

The withdrawal partially caters to the country's Herculean reform of its problematic banking system, which has accumulated huge bad debts, some of which come from financially defunct State enterprises.

Now that major Chinese State-controlled commercial banks are pondering selling shares in the stock market and the State is reforming the industry, banks have been urged to step up risk controls and stop subsidizing bankrupt firms.

A more critical consideration concerns the amendment to the country's bankruptcy law.

Promulgated in 1986, the bankruptcy law was premature when it was created against the backdrop of "policy-oriented" bankruptcies. It cannot reflect the current economic realities in China, where the market and the law are starting to share the burden from administrative forces.

It takes a long time and a great deal of effort to amend the law to cater to market economy rules. The draft amendment was said to be a review of the country's legislature for the third time early this year, but this was merely a rumour.

The labour is a result of controversies between various interests on the issue of priority of the use of the corporate assets after bankruptcy.

Experts and concerned parties are divided as to whether the assets should be earmarked for paying back corporate debts or compensating workers affected by the bankruptcy.

In the draft submitted to the national legislature last October, the workers were prioritized. The All China Federation of Trade Unions and the Ministry of Labour and Social Security had expressed endorsement for the new stipulation. They said the new act would protect workers' interests and help maintain social stability.

The central bank was opposed to the article. Zhou Xiaochuan, governor of the People's Bank of China, has said on various occasions that such a legal stipulation would prompt the banks to take pre-emptive measures to ward off possible risks in granting loans to enterprises, which would jeopardize the interests of capital-thirsty companies.

Wu Xiaoling, vice-governor of the central bank, holds that the bankruptcy law should, as usual, protect the interests of creditors. The protection of workers' interests should be governed by other laws such as social security law and labour law.

Li Shuguang, one of the drafters of the amended law, echoed Wu, saying the bankruptcy law should not play the role of social security legislation, and that the maintenance of social stability could be achieved by various means, not necessarily through a tailored bankruptcy law.

Banking experts also warn that failure to protect creditors' rights may lead to increased bad debts in the financial system and create financial risk.

Lawmakers are in a real dilemma.

As a compromise, the new draft law will reportedly stipulate that market-based bankruptcy practices shall be sought while "special cases" can still be decided by relevant State Council regulations, leaving the door open for fiscal support for those insolvent State enterprises undergoing a "policy-oriented" bankruptcy.

And this is why the State has put forward the four-year timetable and accelerated the pace in ending free-meal bankruptcy rules, making way for the introduction of real, market-oriented bankruptcy procedures.

(China Daily May 23, 2005)