December 31 was significant for China's financial industry. This was the day when the first wave of bad loans from the Big Four state banks – US$170 billion taken off their books in 1999 – was supposed to be cleared.
The deadline wasn't met but the work of the asset management corporations (AMCs) set up to manage the non-performing loans (NPLs) was not the embarrassing underperformance expected this time last year after much foot-dragging over sales.
PricewaterhouseCoopers estimates that there was US$30 billion of the 1999 loans remaining by mid-2006, with a few sales pending. NPL sales to foreigners, US$12 billion before November 2005 from a total of US$90 billion, had nearly doubled by February 2006. There are few official statistics on the four AMCs – Cinda, Great Wall, Oriental and Huarong – but one or two may have more or less rid themselves of the 1999 offerings.
"Things have speeded up in the last year, making significantly more dispersals than in the previous three years," said Ted Osborn, head of PwC's business recovery services practice in Hong Kong. "The question is: will this continue into 2007?"
Foreign investors appear confident that it will.
Phil Groves, president of DAC, which specializes in distressed opportunities and has bought a number of NPL portfolios, says that sales only really started in 2001 and the market is taking time to mature.
"Back then the regulations weren't clear but they have become clearer in the last two years," he said. "Approvals are faster and the structures being used now are much simpler."
With a more transparent and sophisticated system, a steady flow of NPL auctions is expected. And there is plenty of bad debt up for grabs.
According to the banking regulator, there was approximately US$160 billion in NPLs held by China's commercial banks at the end of September. PwC has calculated that another US$153 billion has been transferred since the 1999 batch.
A Fitch Ratings report in May put the total number of NPLs at US$403 billion with another US$271 billion in problem loans lurking on the banks' books. Another report by Ernst & Young, later withdrawn, claimed China's full NPL exposure was US$911 billion.
Despite this consistent supply, the foreign parties interested in buying Chinese bad debt have changed considerably.
Those involved in the first NPL sale to foreigners – a 2001 Huarong auction that saw a US$1.3 billion portfolio picked up by Goldman Sachs and a Morgan Stanley-led consortium – are now rarely to be seen on the buyer lists. In recent years, it is the likes of Mellon and Cargill that have come to the fore.
"This year we've seen more sales but prices have been higher," said Osborn.
The AMCs received interest-free loans from the central bank to cover the transfer of the 1999 NPLs, which were taken at 50-100% of their face value but sold for as little as 5-10%.
However, interest is charged on loans made to facilitate the transfer of US$150 billion in NPLs in 2004 and 2005. Having already paid over the odds for the bad debts, the AMCs have tried to charge investors more in order to cover their costs.
"The AMCs are forced to buy at US$0.30 on the dollar and don't want to sell at less than that," said Osborn. "You need to be able to collect US$0.30 but is there enough profit in there that someone will want to buy it?"
Now, foreign players may have other investment options with better returns. The books of debt-ridden companies often tell only half the story so investors have to put staff on the ground to carry out due diligence before purchase and service the debt afterwards. Local knowledge can uncover hidden assets that can be used as leverage, but it can be costly.
"Some of the early players didn't view it this way but it's a people intensive market," said Groves, pointing out that DAC has 45 people in China.
A PwC survey in December of foreign investors in the NPL market found 89% of respondents expect to acquire NPLs in the next 12 months but two-thirds also plan to invest in individual distressed loans. Real estate, private equity and high-yield lending are also popular.
DAC's preferred means of dealing with NPLs is through restructuring not foreclosure. For example, by buying up the debt and injecting capital into the assets, the company found itself in possession of a five-star hotel in northern China.
"There are lots of real estate opportunities where the builder is in the middle of the project and unable to get local backing so goes looking for a partner," Groves said.
In an increasingly open economy, it is easier for investors to seek out distressed opportunities on their own and implement restructuring plans in exchange for equity. Coming in before loans turn sour could prove more lucrative than waiting for NPLs to drop off the end.
With so much competition, the pressure is now on the AMCs to keep foreign players interested.