Bankruptcy is the most important part of any economic crisis. It is the plumbing of economics. It allows the market to flush away the inefficient businesses and reallocate capital to efficient businesses. Most countries have bankruptcy laws and many investors assume that they are all the same. But all laws have a problem regardless of the country or the legal system. They are just pieces of paper. To give life to law requires an entire legal infrastructure. This requires fairly honest courts and methods for enforcement. The quality or economic efficiency of legal infrastructure varies widely from country to country. Of course certain areas of law are abused more than others. Tax law is unpopular for obvious reasons, but bankruptcy cannot be far behind.

Bankruptcy is about death, the death of a business. It hurts the owners or shareholders, management and employees. All of these people lose money and jobs. And exactly who benefits from this process? Creditors, banks and bond holders, the people who supplied the loans and the credit in the first place.

Bankruptcy suffers from a fatal flaw. There are usually more and better organized shareholders, owners, managers and employees than there are banks, depositors, creditors, and bondholders. So the political power usually ends up with the former rather than the latter. When bankruptcy becomes necessary in times of economic stress, politicians look for scapegoats. Creditors and banks make easy targets especially if they are foreign. So telling creditors to forget repayment is often much easier than calming a mass of unemployed angry voters or protestors.

Yet credit is essential to economic growth. In game theory, a debtor’s best move is not to repay the debt. Creditors know this and their best move is not to lend. So without adequate legal protections economic growth can come to an end. The issue is especially important when the owner is the government.

Government owned entities cause trouble because of their size and the politics involved. This problem is most prevalent in emerging markets, but not limited to them. The real estate financial giants Freddie Mac and Fanny Mae in the United States were allowed to amass huge quantities of toxic assets as a result of political power and poor management. Both are private companies and both are or were insolvent. They have avoided the bankruptcy courts due to support courtesy of the US taxpayer.

The situation in China is especially instructive. Not because it is unusual, it isn’t. It is interesting because of its size.

China’s first bankruptcy law was put in place in 1987. Unique among most bankruptcy laws it applied only to state owned firms. Most bankruptcy laws are silent about insolvency of government related firms, but in those days that was all China had. Although quickly outmoded, it was not replaced until 2007 twenty years later.

The law’s one and only test came in 1999 and it was a disaster. In the 1980s several Chinese provinces and cities established vehicles called “Itics” (International Trust & Investment  Corporations) to spur long term development for infrastructure projects. Without any restrictions and with the ability to attract foreign investment, they expanded rapidly an estimated 100 times over. They were able to diversify into a host of businesses, including securities brokerage, equipment leasing, silk textiles, leather and plastics, international trade, manufacturing projects, hotels and other real estate investments.

Some of these firms were way over extended when the effects of the Asia currency crisis hit China. One was GITIC, the “itic” established by Guangdong. In January of 1999, a local court declared GITIC bankrupt with over $4.5 billion in debts of which about $2 billion were owed to foreigners. The bankruptcy sent shock waves through the financial community. The lenders had assumed that the debts were guaranteed by the government. The realization that they were being repudiated dried up credit to China overnight.

The government in Beijing realized its mistake and shored many of the other of the 240 “Itics” that were having severe financial problems. There were no more bankruptcies, but it was too late for GITIC. Creditors eventually received about 3 cents on the dollar.

Memories fade. Creditors no longer relied on the implicit government guarantees. Chinese companies were able to borrow on the international credit markets at low rates. Investors mesmerized by the spectacular growth of the Chinese economy assumed that it would never stop in the same way that investors assumed that the price of American real estate would always increase.

Of course nothing lasts forever and China has not been immune from the global recession. Investors in Asia Aluminum and FerroChina learned to their sorrow that even Chinese companies can fail. In both cases, the investors thought that they had the protection of other laws. They didn’t. Creditors have yet to pry either assets or information from the Chinese courts.

The problems of China are not unique. There are similar problems all over the world often hidden from view by intentionally distorted information. China’s case is different only in size. Vast sums have been lent in China mostly by Chinese banks, but undoubtedly also by international lenders based on the optimism of the China growth story. Now vast sums are needed by other governments. To accurately determine the risk of these investments, it is important to look beyond the numbers to the legal institutions that provide transparency and consistency, because when things go sour, they are your only protection.