Unremitting debtors

With Deutsche Bank and AIG closing in on the US$2.5 billion "Huarong III" debt portfolio following a successful auction, China’s bad debt juggernaut may at last be picking up pace.

The auction run by Huarong Asset Management Corporation – one of four state-owned AMCs set up in 1999 to dispose of the largest commercial banks’ non-performing loans – saw a number of new foreign players enter the bidding, all of whom want a slice of the US$235 billion worth of bad debt on the AMCs’ books. And 2006 could be a year of rich pickings. Cinda AMC plans a US$470 million NPL auction early in 2006 as part of plans to offload US$14.9 billion worth of bad debt by the end of the year while the remaining two, Orient and Great Wall, are also talking of sales in the pipeline.

"For the first time since I came to China we are seeing an upturn in activity," said Jack Rodman, who as managing director of Ernst & Young Asia Pacific Financial Solutions, advised on China’s first international NPL auction in 2001.

However, the sale of distressed debt in China still lacks transparency and a clear sense of direction. Deal flow has also been incredibly slow: the four AMCs have acquired US$325 billion of NPLs from the banks and disposed of only US$90 billion, or 27%. "I think the market has been very consistent over the last three years in its inconsistency," said Ted Osborn, a partner with PricewaterhouseCoopers’ Business Recovery Division who also advises on debt sales.

"It’s not like other markets in Asia that have more systematic sales processes in which series of auctions are done to a precise format. That just isn’t likely ever to happen in China."

Chaotic times
Two auctions held by Cinda in Qingdao and Tianjin last year encapsulated the chaotic nature of the market. The foreign investment community staged a boycott in Qingdao when Great Wall entered the bidding, claiming that a state-run AMC had an unfair competitive advantage.

The boycott was extended to cover Tianjin as AMCs once again registered to bid and it took a re-auction in September – which the AMCs pulled out of – before the Tianjin NPLs were finally sold to Avenue Capital.

In Rodman’s view, it all comes down to a lack of government control – the absence of an "NPL csar" to push things forward.

Korea Assets Management Corporation (KAMCO) received a government mandate to sell as many debts as possible to overseas investors as long as it cleared the books; Taiwanese banks were given strict instructions to reduce NPLs by 50% within two years and establish risk-based capital levels of 8%; and in Japan, the banks were threatened with nationalization if they did not rid themselves of bad debts. China’s AMCs are in need of this kind of direction.

"I think you have to take what was good about KAMCO and try to replicate it in China," said Robert Appleby, chief investment officer of hedge fund operator Asia Debt Management. "You need one seat of authority; you can’t have politics running it."

Foreign investors have accounted for just US$12 billion of the US$90 billion in NPLs sold. While most countries are reluctant to sell distressed assets to foreigners, the dominance of domestic players in China is cemented by their less stringent requirements in terms of contracts and due diligence.

There are pitfalls to favoring locals, though. The 2005 National Audit Committee report found that 13% of debt sales to domestic operators – who tend to be small scale entrepreneurs or municipal governments helping out local state-owned enterprises by taking over their bad debts – involved some form of corruption.

Domestic inefficiency
Effective settlement of the NPLs is also an issue. According to official figures, domestic investors who purchase bad debts and the AMCs themselves recover an average of 20 cents per dollar on each NPL. But this represents gross cash recovery over time and doesn’t reflect collection expenses.

"If you sell to a foreign company for 35 cents on the dollar, that is 35 cents today with no overheads," said Ernst & Young’s Rodman. "In 2004, we sold ‘settled assets’ for CCB to Morgan Stanley for 35 cents on the dollar – all cash, up front."

On the whole, the likes of Citigroup and Morgan Stanley have the experience and know-how to run a tighter ship than the AMCs. And, being commercial entities, they are also more pragmatic, settling for a 10 cents per dollar return on a loan over one year as opposed to the AMC approach of waiting five years for a 20 cents return.

"I think what makes them more effective is that they’ve got people on the ground and are willing to invest time and money into pursuing portfolios," said PwC’s Osborn.

When it comes to forcing a settlement, nothing is more effective than threatening the seizure of assets through litigation, and the Chinese courts have proved reasonably effective in enforcing creditors’ rights. But building relationships with those involved is also important.

"China is full of people who come out of the woodwork when you have a situation that needs resolving," said Osborn. "These middlemen – ex-government officials, ex-bankers, lawyers – can, for example, arrange for you to meet a guy who has influence over a labour dispute at a company. The connections and relationships help as they can give you leverage over the debtor."

It is often the case that foreign investors find they have more leverage than domestic operators. A state-owned enterprise with bad debts on its books may be unwilling to reach a settlement with an AMC or an operator with state connections as, in the directors’ minds, it merely represents the transfer of money from one arm of the government to another.

Willing to talk
"If a foreigner has taken over the debt, they’re much more willing to negotiate," said Osborn. "The Chinese enterprises that have these loans are typically poorly run SOEs, but they have employees and everyone is looking out for their livelihoods. They want to talk."

Judging by best practice in other countries, it would be most productive for the banks to assemble specialist recovery teams and manage their own loan portfolios. But under the current rules, China’s banks have to pursue loan settlements in full, with no discounts allowed.

Further banking reform is expected to bring change, though, and this puts the future of the AMCs into the spotlight. There has been talk of winding down or amalgamating them once deregulation of China’s financial sector starts to kick in at the end of the year, and the AMCs appear to be trying to diversify in order to extend their lifespan.

The vice-president of Huarong told the Financial Times in November that the company wanted to enter the securities industry as part of a bid to transform itself into an investment bank. A fund management joint venture between Cinda and Commonwealth Bank of Australia’s First State Investments is said to still be on track despite the recent sacking of the head of First State’s Hong Kong operation.

But diversification can’t be allowed to obstruct the AMCs in the pursuit of their key objective: complete clearance of loan holdings by 2009. Ernst & Young estimates that, at the 2004 rate of progress, it would take them another 27 years to reach this goal.

As for the next five years, PwC’s Osborn is careful not to place too much faith in recent activity, predicting more of the same.

"You’ll see experiments in letting banks manage loans themselves and sales to foreigners will continue," he said. "But there are never any ‘big bangs’ in China. No matter what they try, it’s always a small stone in the pond and the ripples aren’t that big."