China's Suntech bailout shows no appetite for creative destruction

* Bailout of Suntech one in a series

* Beijing wary of social instability resulting from mass layoffs - economist

* Airlines, shipping industry consolidations showing mixed results

* Keeping firms in saturated sectors afloat puts broader competitiveness at risk

By Pete Sweeney

SHANGHAI, Oct 31 (Reuters) - The looming bailout of Suntech Power may mark a temporary victory for the city of Wuxi in its struggle to keep its champion employer afloat, but it highlights a singular weakness in China's reform strategy: a deep-rooted political inability to allow inefficient businesses to go bust.

As Chinese leaders prepare to convene for a key economic reform meeting in mid-November at which they will establish the policy template for the next 10 years, dealing with widespread industrial overcapacity is supposed to be at the forefront.

A plan issued in October by the China's State Council, the country's cabinet, said it would block new projects and rely more on market mechanisms to get control of overinvestment in underutilised sectors.

To do that it must overcome the impulses of local governments such was Wuxi's, whose investment arm submitted a letter of intent on Wednesday to invest $150 million in Suntech Power's Chinese subsidiary - which is swamped in some $1.76 billion in debt - and restructure the company.

"Although this represents forward progress of a sort, it's not nearly enough to provide any comfort for long-term investors," Morningstar analyst Stephen Simko said in a research note. "Suntech remains a toxic name."

The deal will leave foreign investors with slightly more than the nothing they would have gotten if the firm liquidated, but it will also ensure that Suntech employees will not feel the pain.

This is hardly the first time this has happened - while New York-listed Suntech Power defaulted on an overseas bond in March, China has never allowed a formal corporate bond default at home.

The rescues have not been limited to major listed companies such as Suntech and LDK Solar, but have also been extended to macreconomically insignificant unknowns including chemical fibre manufacturer Shandong Helon; Chaori Solar Energy Science and Technology ; and Yichang Three Gorges Quantong Coated and Galvanized Plate.

"There's no political support for dealing with overcapacity," said Zhu Haibin, economist at J.P. Morgan.

This unwillingness has contributed to rising levels of corporate debt in China, which Zhu estimated now stands at a comparatively high 125 percent of GDP.

Economists say much of China's overcapacity is not a product of market failure but rather of the overweening ambitions of local Chinese politicians.

Most of the affected industries are either directly or indirectly related to sectors Beijing designated as "strategic" in previous economic plans, including clean energy, steel, and shipbuilding.

TOO MUCH MEDDLING

Su Bo, China's vice-minister of industry, told a conference in September that "administrative interference" in industry was one of the biggest causes of overcapacity, adding that preferential policies in areas such as land allocation had distorted the market and created unfair competition.

The subsidies and protections Beijing has granted its strategic industries have damaged relations with trading partners, who routinely accuse Chinese companies of dumping products into foreign markets to suppress competition.

The policy has also engendered destructive price wars at home between different companies selling identical products, all of them insulated from bankruptcy by their local governments.

In the solar sector, for example, local governments quickly perceived that assembly of solar panels was both low-tech and labour intensive, making it easy to start up a factory and generate local employment.

"Each local government has the ambition to build their own empire," said Zhang Zhiming, head of China research at HSBC in Hong Kong. Zhang has argued that Beijing needs to rein in local government overinvestment, pointing out that steel capacity in China is now seven times higher than Japan's and more than the next 10 countries' combined output.

But Beijing has to balance the economic benefit against the political risk massive nationwide lay-offs would entail.

"Given Beijing desires stability, you cannot rein this in too abruptly," said Zhang. "If you force consolidation, people are going to get laid off and the local economy will get hit."

INEFFICIENCY PANDEMIC

This bodes ill for those who hope the issue will be addressed quickly.

The Ministry of Industry and Information Technology (MIIT) has already ordered some 19 different sectors to reduce productive capacity, but it appears the order is paired with guidance that they should do so without laying off any workers.

Chinese airlines, for example, which saw margins destroyed by minor municipal or provincial government players that were only able to compete through brutal ticket price wars, have been ordered to consolidate in the name of better service.

But a source at a centrally owned airline said that the restructuring was designed less to improve cost efficiencies than reduce competition through generous buyouts.

"We were told we had to buy up smaller airlines, but it was on a 'buy one get one free' basis: If we acquired a good airline, we had to buy a bad one as well," she said.

The source said that the acquiring airlines had been ordered to import the entire staff of the target airline and maintain their salary levels untouched. If the incoming manager was paid more than an internal manager of the same level, the source said, the internal manager would be given a raise to catch up.

Shipbuilding is another industry that continues to suffer from a capacity glut in the face of weak global demand. But here too it seems that there is strong resistance to demands that local governments close idle shipyards.

In August, Beijing moved to raise lending standards for shipbuilders in an attempt to starve the weaklings out, and domestic media have reported that a swathe of small shipyards have gone bust.

But the crackdown did not last long, and now Beijing has announced plans to subsidise "green shipbuilding", which some industry observers have interpreted as code for another surreptitious bailout that will allow weak shipyards to rebrand themselves as "green" in order to continue to receive government support.