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China: Handling Bad Loans Badly

Beijing takes a lot of steps backward in cleaning up bank balance sheets.

China’s central bank will soon announce bank loan statistics for September, and there have already been press reports that new lending may be increasing again after a lull in July and August. On top of record new lending in the first half of the year, despite a global slowdown, this is provoking new fears of another nonperforming loan crisis on the horizon. The dilemma for Chinese policy makers will be how to deal with that problem.

This is a critical question because banks are the main intermediary of credit in China and nonperforming loans (NPLs) act as a drag on growth by weighing down bank balance sheets. As of July, the latest month for which figures are available, Chinese bank NPLs totaled approximately 500 billion yuan ($73 billion)—dwarfing those of all other Asian countries except Japan. Shedding these loans allows lenders to rebuild their balance sheets and recapitalize. This exercise is particularly important for Chinese banks, which are growing rapidly and are often capital-constrained—especially when Beijing forces them to lend, as the authorities did earlier this year to help stimulate growth and may well be doing again.

Regulators must first re-examine the structure of the China NPL market. In many parts of the world, banks can sell their NPLs directly to investors at a discount from the face value of the loans. But in China, with few exceptions, banks are only allowed to unload their bad loans to four asset management companies (AMCs) that were established by the government a decade ago as part of a master plan to restructure the nation’s banking system. These companies act as loan wholesalers, selling the NPLs they acquire to third-party investors.

This system has never worked particularly well in China. In establishing selling prices the AMCs focus on securing a price that will cover the cost they paid to the bank for the loans plus a small profit. Investors focus on the amount they’re likely to recover on the loans they buy and the amount of time they think it will take to collect on them. There isn’t often an equilibrium between these two values, so deals rarely get done. Many prominent investors, including Goldman Sachs and Morgan Stanley, quit investing in Chinese NPLs years ago.

Many of those who stayed have had trouble collecting debts through the court system. In late 2007, courts across the nation invoked a self-imposed “three suspension policy”: the suspension of filing of new NPL-related cases, obtaining judgments on existing cases and execution of decisions pending Supreme Court guidance. The move dealt a blow to investors hoping to use the courts to effect payment on their existing loans and has resulted in vastly reduced returns on portfolios as monies remain uncollected.

In March, investors took another major hit when the Supreme Court issued guidance instructing courts not to accept cases against state-owned or state-controlled enterprises if the debtor is in the midst of a reorganization, or against state-owned banks if an investor finds an undisclosed technical fault with a loan that hinders collection after the AMCs have sold the NPLs to the purchaser. The Court also ruled NPL sales can be invalidated for any number of reasons, including if the debtor or guarantor is a government body; if auction formats are not being properly followed, which is often the case; if necessary regulatory approvals haven’t been obtained; or in “any other situations involving national or public interest.” While this guidance served mainly to protect state interests, it was at least clear and investors could use it to price new portfolios.

The real trouble came in July, when the Supreme Court ruled against Swiss bank UBS in a case involving a state-owned enterprise guarantor. The Court’s March guidance clearly stated that when NPLs are transferred by the AMCs to investors, the underlying guarantees remain valid and the guarantor is not required to give its consent for the transfer of the loan. This meant that a valuable piece of land pledged as collateral by a guarantor would remain a prime source of recovery for investors, even if the guarantor didn’t like the fact that someone else now owned the underlying loan.

However, in the UBS decision, the Court cited a 2004 law that said the guarantor must provide consent for the transfer, and further, that the details of the guarantee must be registered with the local State Administration of Foreign Exchange bureau. The Court reasoned that since UBS hadn’t obtained such consent and had not registered the guarantee, the guarantee was invalid. Lawyers and investors believe this ruling is at odds with the law and with established market practice, but there is no sign yet of whether the Court might reconsider any time soon.

The ruling has huge implications. Most NPL investors derive a big source of their recoveries from collecting on guarantees, including collateral pledged by guarantors. If the UBS decision is followed by lower courts as expected, investors will not only have to provide details of guarantees when they register them with the government, but they must also get the consent of the guarantors for the guarantees to be effective. Many guarantees may simply disappear if guarantors won’t willingly consent to a transfer. And there’s the effect on the market of yet another instance of regulatory uncertainty. As one investor recently told me, “every time we think we understand the rules the authorities throw a new roadblock in our path.”

The impact is already being felt. This year to date, I am aware of only two portfolio sales to foreign investors by the AMCs: one to Shoreline Capital, and a 3.2 billion yuan portfolio sold by China Orient to KAMCO, which has yet to close. None of the major China NPL investors over the past few years—including Cargill, Distressed Assets Consulting, Avenue Capital, G.E. Capital, Bank of America, Société Générale and ING—appear to have any appetite for deals until the guarantee issue becomes clearer and the AMCs lower their asking prices.

Meanwhile, China’s pile of NPLs is growing, saddling banks with bad debts. Foreign investors can help solve this problem, if only Beijing will let them.

Mr. Osborn is a partner at PricewaterhouseCoopers Hong Kong/China specializing in debt restructurings and NPLs.

Source: WSJ 04.10.2009

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