China ‘bad bank’ plan perplexes market amid secret debt workouts
The Chinese government says it wants to transform its asset management companies – established to take on growing bad debts in the banking system – into commercially driven enterprises. In reality, a lack of transparency on portfolio loans means analysts are none the wiser as to the scale of the problem and the resolution process for legacy loans.
Investors looking for information on the level of credit impairment in the Chinese banking system are unlikely to learn much from the next round of non-performing loan (NPL) workouts. After reporting Rmb539.5 billion ($87.8 billion) of NPL in the commercial bank sector at the end of the second half – the seventh consecutive quarter of increased NPL balances – the Chinese government is revitalizing its asset management companies (AMCs), or bad banks, with an infusion of private capital to acquire and work out the nation’s stock of problem loans. One of them, China Cinda Asset Management, has raised capital from foreign investors including western investment banks, ahead of a $3 billion IPO planned for this December, while China Huarong Asset Management is also said to be courting a $1.5 billion investment from global investors including European and US investment banks.
The move reprises the government’s 1999 NPL strategy, when China formed four AMCs to receive some Rmb1.4 trillion of bad loans from its four state-owned banks ahead of those lenders’ stock market listings. During the original process, the government required the AMCs to buy the assets at face value, rather than at fair value based on credit performance, presumably to support the appearance of balance-sheet strength at the soon-to-be-listed public lenders. According to Christine Kuo, a Moody’s analyst in Hong Kong covering the asset management sector, the AMCs are shrouded in secrecy, making analysis difficult. “The AMCs are not listed, so they are not required to disclose detailed information,” she says. “Although Cinda issued its bonds in China, the level of financial disclosure is minimal.” It’s hard to say how effective the AMCs have been at recovering bad debts since 1999, given the face-value policy.
However, a report from the China Banking Regulatory Commission (CBRC) in 2006 revealed an average cash recovery ratio of just 20% for the par valued policy portfolios. “The 2006 CBRC report is the latest piece of information that the government has disclosed about the performance of bad loan workouts since 1999,” says Kuo. However, Chinese financial markets have changed a lot since then and the bad-bank plan has allowed the good banks to show massively improved balance sheets. Indeed, market participants say the NPL ratio in 1999 was more than 20% of Chinese banks’ total loan balance, and could have been as high at 40%. By contrast, the latest CBRC figures show total NPL balances represent less than 1% of the total loan balance. Moreover, during that time the government has begun to allow the AMCs to acquire loans from banks at prices more reflective of fair value, although public disclosure falls short of specifying what ‘fair value’ means in practice.
“The government clearly wants to transform the four AMCs into more commercially driven operations,” says one market source. “Although it has re-organized Cinda and Huarong into joint-stock companies in preparation for public listing, we still don’t have much transparency on the portfolio performance. “It seems that the government has helped them somehow resolve some of the face-value policy portfolio loans, but the details haven’t been disclosed.” Although the resolution process for legacy loans remains murky, the prospectus for Cinda’s bond issue last year shows debt-for-equity swaps have become a key tool in driving recovery value, with AMCs converting bad debts into equity stakes in more than 600 of the country’s state-owned enterprises.
These stakes have generated notable profits in some cases, and have attracted the attention of foreign distressed-asset specialists. “The Chinese economy and property markets have done very well, and much of the collateral in these loans is related to real estate,” says Kuo. “So long as the AMCs are able to receive market pricing on the next round of NPLs, they are well positioned to make a significant profit.” With Chinese NPL balances increasing for the past seven quarters, according to the CBRC, the re-organized AMC sector will have an important role to play in the great Chinese credit clean-up. Unless the government embraces a more transparent, market-based approach to NPL pricing, it’s not clear what level of profit foreign investors can expect to make. It’s likely, however, that process will probably involve more political intervention than they are used to.
The very idea of a non-market force artificially propping up the market is likely to further sow the seeds of mistrust between foreign investors and Chinese bank regulators. Just like the Chinese banking crisis of the late 1990s, a bailout of Chinese banks is unlikely to dampen depositor confidence or even substantially knock loan growth, say analysts, but moral hazard will surely be a long-term consequence of the NPL workouts.