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CHINA'S DISTRESSED DEBT RICE COOKER
 

By Mitchell Silk and Richard Malish. Mitchell Silk is a partner and head of the China Group in Allen & Overy LLP's New York office. He was posted in Beijing from 1986-87 and in Hong Kong from 1993 until mid-2005. Richard Malish is an associate and member of the China Group in Allen & Overy LLP's New York office and has worked in Hong Kong and Shanghai.

In communist China, state workers were promised their "iron rice bowl," a Chinese idiom referring to guaranteed lifetime employment in state enterprises. State-owned enterprises, meanwhile, have been given their financial "rations" in the form of preferential loans by state-owned banks at little or no interest and loose repayment obligations.

While China's policy of favorable government lending fed the economy for years, the rice pot has now become a pressure cooker as the Chinese banking system has become flush with non-performing loans (NPLs). Recent pressures may force the pot to boil over and bring the potentially enormous pool of assets to market. We examine recent challenges to investors wishing to capitalize on China NPL opportunities, and discuss how they can take advantage of the market without getting burned.

Establishing the Framework

China's banking sector is led by the big four state-owned banks (the Big Four): Industrial and Commercial Bank of China (ICBC), Bank of China, China Construction Bank and Agricultural Bank of China. These banks were instrumental in using commercial lending to carry out Beijing's economic campaigns with so-called "policy loans." But the banks were never profit driven given their large portfolios of "policy loans" and they made little effort to compel state-owned enterprises to repay.

As a result, the big four have amassed, by conservative estimates, a legacy of over US$400 billion in NPLs. They also have the highest NPL ratios of any banks in the world. The big four Chinese banks report an NPL ratio (as a percentage of total loans) of just under 11%. However, private estimates range from 20% to 45%, which could represent over 40% of China's GDP. The recent construction lending boom and greater sophistication in categorizing loans may also lead to further increases.

The Chinese government has prioritized cleaning up the banks' balance sheets to relieve them of impending insolvency, ready them for public listing, and to make them competitive in time for the liberalization of the banking sector in 2007 under China's WTO commitments. By way of example, ICBC is undergoing a major restructuring in preparation for its long anticipated international public offering. As part of that, in the last year the Chinese government recapitalized ICBC by $15 billion and disposed of $85 billion in NPLs. The restructuring and recapitalization resulted in a 9.12% capital adequacy ratio and a 4.58% NPL ratio (versus a high 19% NPL ratio end-2004).

In an attempt to ease the NPL burden of the Big Four, Beijing established four asset management companies (AMCs) - China Huarong Asset Management Corporation (Huarong), China Great Wall Asset Management Corporation (Great Wall), China Orient Asset Management Corporation (China Orient) and China Cinda Asset Management Corporation (Cinda) - in 1999 to acquire the Big Four's NPLs. Each of the AMCs is loosely linked to one of the Big Four, thereby acquiring asset pools which correlate with the bank's main line of business (The general nature of loans of the Big Four and their corresponding AMC is as follows: Bank of China/China Orient (real estate, manufacturing and international trade); ICBC/Huarong (manufacturing, machinery and construction); China Construction Bank/Cinda (infrastructure), and Agricultural Bank of China/Great Wall (agricultural)). The AMCs were established to maximize recovery on the NPLs through asset resolution and collections. They also have the power to sell NPLs at below market value. The establishment of a fifth AMC has recently been hinted at to resolve the NPLs of the People's Bank of China (PBOC), China's central bank.

By 2000, the AMCs had acquired about $170 billion of the banks' NPLs, thereby shifting a significant amount of risk from the banks to the Ministry of Finance and PBOC. The total loans acquired by the AMCs since their establishment is a whopping sum of US$325 billion.

In 2001, the AMCs began focusing on bulk sales to foreign investors. The first wave of disposals were highly-publicized auctions, such as the purchase by Goldman Sachs and a Morgan Stanley-led consortium of US$1.5 billion in NPLs auctioned by Huarong in 2001 at about 8% of the face value of the loans (although Huarong could receive upwards of 21% of the face value upon successful recovery of the underlying debt). Recently, the focus of most foreign investors is to negotiate bilateral deals with the AMCs and, less frequently, directly with the banks.

The four existing AMCs were expected to finish their task within eight years. But after six years, only US$83 billion worth of NPLs have been sold, about half the total originally transferred. The pressure to sell these NPLs will continue to build as newer tranches of NPLs are transferred to the AMCs.

Hurdles for Foreign Investors

Despite China's clear policy directive to clean up the banks and their NPL portfolios, directly and indirectly, there are still numerous hurdles for the foreign investor. On the most basic level, it is difficult to service purchased loans as many portfolios have a poor level of documentation, making it difficult to identify and establish claim on the relevant assets. Furthermore, NPLs are most often secured with land, but state-owned enterprises (SOEs) tend not to hold the more secure "granted" form of land, instead holding land classified as "allocated", which is owned by the government and can be appropriated at any time. It is therefore difficult to determine what such "allocated" land would be worth on the market.

The most prominent issue is pricing, as foreign investors lack the information necessary to ascertain their position and some AMCs are under fire for recovering single-digit returns. Regulatory hurdles are also commonplace, as approvals from the numerous regulators governing these sales, as well as internal AMC approvals, can take months to obtain. For example, foreign investors have had to wait months (in extreme cases, over 18-24 months) to procure approvals to establish the NPL investment vehicles required to close. Similar regulatory obstacles exist for the establishment of essential servicing platforms.

The most recent example of investor frustration was the public outcry heard when Cinda attempted to sell two pools of NPLs in early 2005: RMB7 billion based in the city of Qingdao and RMB5 billion in the city of Tianjin. Most overseas investors boycotted the auction after Cinda invited the other AMCs to bid for the assets. AMCs have tax exemptions, access to cutthroat state financing and reduced legal fees that give them a marked competitive advantage over international investors. Great Wall ultimately emerged as the winner of the Qingdao auction, but none of the bidders in the Tianjin auction bid above the reserve price. When the Tianjin pool came up for re-auction in September 2005, foreign investors were placated when it was announced that Avenue Asia, an international investment fund with offices in the US and Asia, won with a bid above reserve price (Citigroup is the only reported competitor).

Further complicating the recovery of purchased NPLs is the lack of guidance on the establishment of third-party debt servicing companies, a staple of distressed debt transactions outside of China. Currently, only the purchaser of the NPLs has the right to collect outstanding debts in accordance with the relevant loan agreements. Directives in 1995 and 2000 prohibited the establishment of third party "debt collection companies," which seemed to target "loan shark" collectors who strong-arm small businesses.

The Ministry of Commerce created more confusion in May 2005 when it issued a circular strengthening the 2000 directive outlawing the establishment of specialized debt-servicing companies without Ministry of Commerce approval.

Boiling Point?

The frustrations faced by foreign investors have been recognized by Beijing. In early July, the chairman of the China Banking Regulatory Commission, China's top auditor, issued a scathing indictment of the AMCs in light of reports of financial mismanagement and the increasing reluctance of foreign investors. The Ministry of Finance is drafting a reform plan for the AMCs and considering whether to cut the level of state ownership.

The government's recent revaluation of its currency may also increase the number of NPLs, placing further pressure on banks and AMCs to place NPLs in the market. As Chinese products become more expensive to international buyers, Chinese exporters will find it more difficult to service their debt to banks.

Meanwhile, the banks' capital adequacy ratios will be simultaneously hit. Chinese banks already have some of the lowest capital adequacy ratios in the region. The banks' capital is now denominated in US dollars, while its loans are generally denominated in RMB. A weakening dollar in relation to the yuan results in a fall in the banks' capital to assets ratio, which could exacerbate NPL positions.

Other political movements have also paved the way for a swell in transactions. The introduction of the PRC Trust Law in 2001 laid the groundwork for securitizations in China. AMCs are looking at securitizations of NPLs as a way to retain residual upside, thereby avoiding criticism for selling too low.

Investors are also anxious to see how the new draft Enterprise Bankruptcy Law, which should be implemented by early 2006, will affect the market for NPLs. The draft law should give NPL purchasers a clear avenue for realizing on these loans. However, carve-outs for state-owned enterprises may continue to sideline creditors.

Foreign Investors Set Their Own Table

The Chinese NPL market is certainly a long-term investment that requires a strong stomach. Despite the more well-publicized quandaries, there are certainly methods to navigate through the risk.

The method many investors are finding the most advantageous is through private bilateral transactions. Such transactions had previously been thought unlikely, as the AMCs have been encouraged to conduct their disposals through auctions to receive the best price, despite the fact that investors are willing to pay a premium for the certainty of closing a deal.

This perception changed when Citigroup announced the signing of a RMB2 billion portfolio transaction with Great Wall in 2004 consisting of more than 600 borrowers from Guangdong province. The transaction is believed to have been negotiated over the course of two years.

The assets pools are also getting much smaller. Besides isolating better deals, these smaller transactions are less likely to raise public scrutiny. Investors have even been investigating single credit situations.

Foreign investors are also aggressively seeking out well-placed local partners. Citigroup took the lead in this approach after acquiring a 16.4% stake in Hong Kong-listed company Silver Grant International Industries, which is 20% owned by Cinda. Local partners can not only spot deals but also help accelerate the approval process. They can also be useful in navigating around the regulatory maze for transaction-related, acquisition vehicle and servicing vehicle approvals.

Once they acquire the NPLs, foreign investors are also developing their own best practices to China in regards to servicing. Experience has shown that, despite Chinese fears, the presence of foreign debt holders does not lead to burdensome disruptions to the debtor. Many foreign investors have chosen to collect through direct, consensual negotiations with the debtor or to seek the assistance of local governments, thereby collecting on debt much faster than lengthy, politically-driven domestic solutions. Where negotiations are not possible, investors are recovering their investment through a mix of resale, disposal of collateral and recourse to guarantors. Although less common, some more aggressive investors prefer going directly to court to establish a legal claim over the relevant assets.

Conclusion

Foreign investment in China's NPL market has been a mere US$12 billion (face value), or 3.7% of the US$325 billion of NPLs acquired by the AMCs. However, despite the delays and risks in the market, there is still a healthy appetite for Chinese NPLs. Investors with their ear to the ground, experienced legal counsel and a bit of patience are already making rewarding investments in the market, and as forces continue to push Chinese NPLs to the market, we should see the number of investors at the table increase.


 
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