CHINA: Opportunities, risks of bad debt resolution

Analysis

Countdown to foreign entry in the banking sector is pushing deep financial sector reforms. The greatest concern centres on the four large state-owned commercial banks (SOCBs), which contain most of the country's 1 trillion dollars in household savings (see CHINA: Banks at risk as WTO opens door to foreign rivals - OADB, June 7, 2002, I. ). The banks have non-performing loans (NPLs) officially totalling 23% of loan portfolios as of August, or 25% of GDP. A fuller accounting of NPLs, including those transferred off balance sheet in 1999, could put the ratio as high as 50%. China now accounts for some 25% of Asia's 2 trillion dollars of NPLs, according to Ernst & Young.

Soft touch . The conventional approach to massive bad-loan problems involves closing banks, forcing owners and depositors to shoulder some of the pain. This is not an option for the SOCBs, given their dominance of the country's depositor base. The alternative is to transfer the NPLs to 'asset management companies' (AMCs) for eventual sale or liquidation. The Ministry of Finance in 1999 transferred 1.4 trillion renminbi (169 billion dollars) of NPLs to four AMCs. In 2001, they were allowed to write down their value, which the banks could not do. Asset recovery has begun:

In the first half of 2002, AMCs recovered 45.5 billion renminbi in cash from 210.4 billion renminbi in bad assets, a 22% cash recovery rate (CRR). This is impressive: analysts initially estimated that CRRs would be below 10%.

By the end of June, Huarong, the AMC managing the NPLs of the Industrial and Commercial Bank of China (ICBC), had disposed of NPLs with a face value of 38.9 billion renminbi, recovering 12.4 billion renminbi in cash, a CRR of 32%.

Huarong has thus far only resolved 7% of its NPLs, and the deeper it delves into its portfolio, the lower will be its CRR, since the best assets are resolved first. The four AMCs initially hoped to dispose of 200 billion renminbi worth of NPLs in 2002. That target now looks optimistic.

Hopeful scenario . Over 80% of the NPLs transferred to the AMCs have been converted into equity. The move is seen as less than ideal, because it means AMCs taking minority stakes in poorly run companies whose managements remain unchanged. However, transfer of these stakes to domestic and foreign companies to manage these companies actively presents a potentially positive outcome:

In November 2001, Morgan Stanley led a consortium of foreign firms that agreed to buy NPLs with a face value of 10.8 billion renminbi from Huarong. The transaction was sweetened by credit guarantees provided by the World Bank. Although returns are to be shared between Morgan and Huarong, Morgan Stanley will take the larger share in the early years.

In December 2001, Goldman Sachs agreed to buy NPLs from Huarong with a face value of 2 billion renminbi. Both deals entail joint ventures with Huarong.

Other deals include a 4 billion renminbi NPL sale from China Construction Bank to Morgan Stanley, and a sale of equities (created via debt-equity swaps) from an AMC to an unnamed foreign firm.

Obstacles . All of these deals await approval from the State Council. A major sticking point is that they involve state assets, including assets in industries barred to foreign investors. Detailed rules have not been issued on this subject and there will be no progress on NPL sales to foreigners until they are. Movement on such a sensitive issue will have to await conclusion of the 16th Party Congress in early November. An experimental sale of major SOE assets in Shenzhen late this year, if successful, should presage progress in developing the wider regulatory framework during 2003-04. Assuming that permission to buy SOE assets is extended, and at low prices (currently 10% of NPL face value), there are still challenges to extracting cash. In this sense, the Morgan Stanley deal, once approved, will be a bellwether for the process more widely, with attention focused on treatment of four issues:

Valuation .Debtors are unlikely to have accurate accounts. Administrative rules governing asset valuation in China are backward, and usually lead to serious overvaluation.

Joint-venture law .The joint venture legal framework was designed for manufacturers, not for financial companies collecting payments, filing for bankruptcy or organising sale of state assets. The law, for instance, does not easily permit the distribution of capital from a joint venture, which needs to happen as loans are resolved and proceeds distributed to investors.

Taxes .Substantial transfer and other taxes on real estate -- collateral for much of bank loans -- erodes investors' returns. The effective tax rate on an NPL transfer is 20%.

Bankruptcy regime .For unviable debtors, liquidation is the only route to asset recovery, and is often the route favoured by foreign buyers. However, despite legislation, China's bankruptcy framework does not function well. Courts are not empowered to declare bankruptcy; a government agency, usually the State Economic and Trade Commission, must authorise it.

A State Council notice in 1998 made the workforce the priority claimant on funds recovered from bankrupt SOEs (in the form of 'rehabilitation payments'), overriding existing legislation. This dilutes the incentive for AMCs or banks to push for bankruptcy, even if it were possible. While new laws are being drafted to boost creditor rights, it will be difficult to reduce the welfare commitments of bankrupt SOEs, given the pressure from rising unemployment (see CHINA: Mounting unemployment jeopardises party rule - OADB, September 30, 2002, III. ).

Outlook . There are signs of progress on distributing profits and forcing through bankruptcy. In April, China Orient AMC remitted the first payment on a 1.8 billion renminbi NPL package sold late last year to an overseas investment fund. The Morgan Stanley/Huarong deal proposes, controversially, a special vehicle with powers to collect debts, negotiate discounted pay-offs, and instigate foreclosure and bankruptcy. From a macroeconomic standpoint, the issue must be resolved in order to staunch the destruction of household wealth, and goes to the heart of China's dysfunctional financial system (see INTERNATIONAL: China makes its mark on global economy - OADB, September 12, 2002, I. ). Central Bank Governor Dai Xianglong in March ordered the banks to reduce NPL ratios by 3 percentage points per year to achieve 15% by 2005. On September 26, Dai suggested the banks are implementing the order, with NPL ratios down 1.5 percentage points since March. However, the fact that well over half of all new loans are still being extended to SOEs suggests that the NPL-generating dynamic is wholly intact.

Constraints on the AMCs are significant. Local governments tend to protect their insolvent SOEs. There is also inaction on the part of AMC management. For some, it is more risky to their political life to "sell state assets too cheap to foreigners" than to do nothing. This is likely to change after the 16th Party Congress, as the general policy tone will be much more favourable to state asset sales, even of large SOEs. The sale of SOEs may indeed be one of the hallmarks of the next generation of leaders, which would represent a huge merger-and-acquisition opportunity for foreign investors.