While most investors are entering China buoyed by visions of a rosy future, others’ preoccupations with the PRC economy are rooted firmly in the past.
The pre-1949 Chinese government issued a number of sovereign bonds on the international market. Come the revolution and the advent of a Communist government, these bonds were disregarded and went into default. More than 50 years on, US bondholders are asking for their money back.
"It’s a debt that needs to be paid," said US cattle farmer Jonna Bianco, who serves as president of the American Bondholders Foundation (ABF). "China has been given full access to our capital markets and it’s time for them to step up and be honorable."
The ABF was set up in 2001 to represent holders of so-called "wallpaper bonds", issued by countries under now defunct political regimes. It has identified over 5,000 people in the possession of bonds issued by China between 1911 and 1939, notably the 1913 Chinese Government Five Percent Reorganization Gold Loan, linked to the price of gold as an inflation hedge.
The Tennessee-based Bianco claims that, based on the current price of gold, the bonds are worth more than US$150 billion.
In the latest bid to force action on these bonds – which China has never expressed an interest in settling – a group of bondholders in Florida is preparing a class action lawsuit against the major credit ratings agencies. They claim that by awarding China a strong rating, Moody’s, Standard & Poor’s and Fitch Ratings have concealed the existence of these outstanding debts.
As a result, China has been unhindered in raising more money on the international markets.
Grounds for action
"We have developed a theory of liability and a theory of injury," said Kevin O’Brien, president of Arizona-based financial advisory firm Sovereign Advisors, who is assisting the bondholders. "The ratings agencies have destroyed the ability of defaulted creditors to enforce collection of the debt contract."
The ratings agencies, who have yet to see the complaint, believe they have done nothing wrong.
"As it is described to us, we believe there is no legal merit to the claim," said a Moody’s spokesperson. Standard & Poor’s issued a similar response.
Adam Lerrick, a former investment banker who worked on the restructuring of bonds issued by Argentina in the 1990s that went into default in 2001, agrees with their stance. "It seems a bit of a stretch holding the ratings agencies liable. They are not parties to the bond contracts."
As Lerrick discovered from his experiences in Argentina, settling defaulted bonds issued by a current government is difficult. But securing payment from a country that has undergone a regime change, he argues, is an entirely different challenge. Even if a judge were to issue a decision that the defaulted bonds be honored, enforcement is largely dependent on finding assets owned by the defaulting government. Embassies and state banks’ international reserves are off limits, so this is not easy.
"The second course of action is to pursue the debtor continuously in the courts," said Lerrick, now a professor of economics at Carnegie Mellon University in Pittsburgh. "The debtor pays simply to eliminate the nuisance."
According to Professor K. Geert Rouwenhorst, deputy director of the international center for finance at Yale School of Management, the nature of this business means that things can get ugly. People are drawn into buying defaulted bonds by the astronomical sums they are worth in today’s money on the basis of interest accrued, when there is really little chance of seeing a return.
"It’s often an investment scam peddled to widows and orphans," said Rouwenhorst, who became involved when asked to attest to the value of some such bonds. "These sorts of pieces of paper can be bought on eBay for US$10."
He insists bondholders are only likely to see partial payment on the face value of the bonds, stressing that no US court has ever enforced a gold clause such as the one attached to China’s 1913 issue.
But the bondholders are not to be deterred. Their argument is tied to precedent: Russia settled a number of defaulted bonds issued during the Tsarist era and, more significantly, in 1987 China itself paid UK citizens 36 cents on the dollar to cover outstanding debts. O’Brien, who credits Margaret Thatcher – "a leader with real backbone" – with forcing the UK settlement through, advises his clients to target a minimum 35% recovery, although the terms and timescale of repayment would need to be taken into account too.
He is currently working on a complaint to the Securities and Exchange Commission that China failed to comply with disclosure obligations by not mentioning the defaulted bonds when registering in 2003 to issue sovereign bonds internationally.
But perhaps the most imaginative solution comes from the ABF, which Bianco says is negotiating the potential transfer of the bonds to countries that have debts with China, thereby allowing them to wipe out some of the money owed.
"We are turning the bonds over at a discount, enabling other countries to settle their debts with China," said Bianco. "It is ethically, morally and profoundly the right thing to do."
O’Brien believes this international offset strategy would work to best effect if the country taking over the bonds has leverage with Beijing. For example, Iraq owes US$12 billion in sovereign debts to China but is also a potentially important oil source for China.
"The country is uniquely positioned to say they have offset the debt without jeopardizing the economic relationship," O’Brien said.
Others, however, remain skeptical. O’Brien suggests that support for the bondholders in Congress might force through legislation championing their cause but Lerrick doesn’t believe there is sufficient political momentum.
"This is not an issue that is of interest to anyone in the international financial system," he said. "It will only become of interest if someone finds a legal technicality that creates some kind of political or diplomatic problem."