Everything just changed for Chinese companies

We may be about to see what it's like when big Chinese companies go bankrupt.

After a weekend at China's Central Economic Work Conference, Chinese officials have laid out some of the details for what promises to be an excruciating reform period for its corporate sector.

"China will create conditions for execution of bankruptcy procedures based on market rules, and speed up trials of bankruptcy liquidation cases..." said a report from Chinese state media agency, Xinhua.

"In China, some industrial sectors have been struggling with weak demand and falling prices while suffering from outdated production ability, pushing their profitability down to dangerously low levels," the report said.

"Monday's measures will allow [the] market to play a bigger role in allocating resources and push under-perform[ing] businesses to exit the market."

Zombies

The problem here is China's glut of so-called "zombie companies" - mostly state-owned corporates with tons of debt. Officials, economists, and investors alike have warned that they need to be restructured, but those restructurings will lead to writedowns at banks, it is unclear how much pain the Chinese banking sector can take.

Here's what the International Monetary Fund said about the situation earlier this fall:

"The high level of credit could weigh on China's growth and financial stability. The efficiency of the investment financed by credit has been falling, with a commensurate drop in corporate sector profitability. This situation makes servicing debt obligations more difficult."

Officials have been talking about this kind of reform for months, but they've been light on details. That's partly because this kind of reform is both difficult (for any country) and unprecedented in China. Big companies just don't go bankrupt.

So far the government has responded to increasingly unprofitable companies by allowing them to take on more debt, but as Societe Generale economist Wei Yao has argued, continuing down that road sets the country up for disaster.

"Having the central government bail out every zombie company and pay for the whole restructuring would not only be very costly to Chinese consumers (the taxpayers) but would also exacerbate moral hazard, thus impeding long-term positive developments of domestic capital markets," she wrote.

"However, there is no formula on how much credit risk China's financial market can handle by itself without plunging into a full-blown crisis."

China is walking a tightrope, in other words.

According to Xinhua, the government will cut taxes for businesses, figure out support programs for the unemployed and come up with ways to handle non-performing assets.

Monetary conditions will remain loose too. The PBOC has already been cutting interest rates to stimulate the economy since the end of 2014, and that will continue through this process.

For their part, companies are being encouraged to engage in M&A to consolidate, cut costs and streamline.

Better find a partner.

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