After 10 years of debate, China is close to enacting a bankruptcy law, a measure intended to raise investor confidence. But it could also be the long-awaited key to unlocking the debt problem burdening China's banks. The National People's Congress is expected to take up the bill at its session beginning this week.
China's current bankruptcy system reflects its old communist command economy in which the government chose which state-owned enterprises would flourish or die.
But China is now increasingly a market economy, driven by private investment. Without an effective bankruptcy law, it is uncertain whether investors can get their money back if a company goes bust.
And Chinese banks remain trapped in a cycle of lending to inefficient state-owned enterprises - despite already shouldering billions of dollars of unpaid loans.
That is about to change. The annual session of the National People's Congress this month is expected to pass a new law updating the bankruptcy system.
Legal experts welcome the measure as an important step. Michael Barker is a bankruptcy lawyer for the international firm, Freshfields, Bruckhaus and Deringer.
"I think the Chinese authorities realized that an efficient bankruptcy regime is an essential cornerstone for building a market economy which is conducive to free enterprise, foreign investment and competition," he said.
Lawyers and bankers complain that under the current system, the Chinese government plays conflicting roles when a state-owned company fails. The government is shareholder, arbiter and creditor, all at the same time.
The government decides whether or not to approve petitions for bankruptcy. In some cases, the government controls assets of troubled companies on the grounds of national security. Workers are paid before other claimants.
Chua Eu Jin is a lawyer at the Shanghai office of the international law firm Clifford Chance.
"The current bankruptcy law passed in 1986 is geared toward public sector bankruptcy and its articles and sections have often been criticized of being debtor friendly or overprotective of the rights of employees," he said.
Lawyers familiar with the latest draft say it has articles similar to those found in Western bankruptcy laws. The new law would uniformly apply to all types of companies and a court would rule on bankruptcy petitions. The concept of a corporate rescue or reorganization under a bankruptcy court's guidance will be introduced.
But the changes did not come easily. It took 10 years of debate to draft the legislation. Mr. Chua says officials prepared for its far-reaching social effects.
"Bankruptcy is often accompanied by wrenching social issues, such as unemployment," he said. "Perhaps there's some recognition on the part of the Chinese authorities that the wholesale introduction of Western style bankruptcy is more likely to lead to the closure of inefficient state-owned enterprises."
The law could unlock the debt burden of China's banks. With a solid set of rules governing insolvency, banks could take steps to have bad loans repaid. The assets of troubled state-owned enterprises could be sold to cover their debts, while viable companies could be restructured and kept operating.
Banks also could more easily sell non-performing loans to foreign companies, which in turn, could take over the debtor businesses and make them profitable.
However, some lawyers, like Mr. Barker at Freshfields, say it is not clear whether the law would jumpstart the sale of these loans.
"The introduction of the new law may mean that Chinese banks might prefer to use the bankruptcy to try to recover loans themselves rather than to sell them to foreigners," he said. " And also all of the current red tape surrounding the sale of NPLs to foreign investors would not have changed."
Despite the law's promise, some are skeptical about how far China will go in implementing it.
Lawyers point out possible problems: The draft suggests an exemption period for certain SOEs. It also is unclear about what happens when bankrupt companies have assets in several countries or when foreign creditors try to seize assets in China. Some experts question whether the bankruptcy courts will be politically independent.
Charles Booth is a law professor at Hong Kong University. He says more even after the law is passed, more work is needed.
"You need to train thousands of professionals, you've to train the judges, you need to make sure that your bankruptcy law is harmonious with other laws and you also have to develop a real corporate rescue culture," he said.
That could take years, say experts. In the meantime, they say, as China takes on more and more features of a capitalist economy, its laws need to keep up with the new changes.