Collecting broken China

Background

Before 1993 the four main state banks had not publicly acknowledged the concept and had never provided against a bad debt. During 1999, the Peoples' Bank of China ("PBOC") established four main asset management companies ("AMCs") in order to deal with the severity of the four state bank's accumulated level of NPLs, estimated by some at the time as equating up to 70% of total loans on average. The four AMCs and source banks are outlined in the table below:

The general mandate of the AMCs was to collect debt, restructure or assign NPLs, convert NPLs into equity, issue financial bonds and borrow from financial institutions and recommend (and underwrite) companies for listing. The loans were then segmented into four categories, from normal through to substandard, and finally loss.

A total of RMB1.4 trillion (US$160 billion) of NPLs was assigned to the AMCs during 2000. This amount represented only a portion of the NPLs then on the books of the four source banks. It is still estimated that the Mainland banking system as a whole has in excess of US$500 billion in NPLs to recover .

According to the AMCs, as at 31 March 2003, RMB 343 billion NPLs have been sold, recovering RMB 71 billion in cash (20%). Many are skeptical of this recovery rate as a benchmark, as it is likely that the first NPLs recovered represent the most viable, or low hanging fruit. This is perhaps highlighted by the widely reported comments by potential investors who have undertaken due diligence of the relatively poor quality of assets within China Huarong's second auction of 22 NPL portfolios. This tender closed last week and we wait to see the actual results with interest.

Many foreign investors, including Morgan Stanley, Goldman Sachs and Deutsche Bank have participated in the disposal of NPLs, and this has attracted a great deal of publicity. On 19 November 2001, China Huarong entered into the first two joint venture AMC contracts with a Morgan Stanley led consortium and a Goldman Sachs affiliate, respectively. What has attracted less notice is the actual establishment of the operating vehicles.

Approval for these joint ventures took more than a year and the relevant transfer of NPLs was only completed in the case of Goldman Sachs in February 2003 and in the case of the Morgan Stanley led consortium in July 2003. Baker Tilly Hong Kong, via its Mainland China network, is currently assisting one of the AMCs to dispose of a NPL portfolio, and guided by the precedent set by China Huarong is liaising with investors to formulate a joint venture structure for such an acquisition.

Regulations dictate what banks and investors can and cannot do in China. A Chinese bank is subject to constraints in dealing with its NPLs. Regulations state that a bank shall establish a system of supervising bad loans, classify, register, inspect and call in bad loans, and collect, make provisions for, and write off bad debts in accordance with the law. Collection includes enforcement of security, set-off, subrogation, and petition for the bankruptcy/liquidation of the debtor.

There are few provisions concerning the disposal of NPLs by a bank A lender need not obtain the borrower's consent when assigning debt. There is some regulatory basis for the direct disposal of NPLs by a bank, without the intervention of an AMC.

However, such regulations essentially prohibit a bank from disposing its NPLs at prices that are below their net book values. And approvals from government authorities are required at different stages of the sale. A bank is also prohibited from settling with a debtor or cancelling part of the debt (without court approval), an essential element in a recognised restructuring in Hong Kong and in most other jurisdictions.

Developments today

Chinese banks are now beginning to deal directly with foreign investors regarding their NPL portfolios and are considering auctions, as well as private deals, despite current regulatory restrictions. Morgan Stanley has concluded a transaction with the China Construction Bank, which is currently going through the approval process and Goldman Sachs is in discussions with ICBC regarding another NPL disposal. Both are private deals.

These transactions are structured in such a way that it is more of a strategic relationship between the Chinese parties and the foreign investors, in which Morgan Stanley/Goldman Sachs are providing their expertise in handling NPLs to help the two State-owned banks to recoup as much as they can. Another development during January 2003 was Deutsche Bank and Xinda entering into a securitisation and packaging agreement, whereby the parties are understood to intend to set up a 50:50 joint venture asset management company, within which Xinda will inject the NPLs and Deutsche Bank will contribute cash. The joint venture will then look to issue bonds or shares in the international markets. In almost all cases, to our knowledge, they are still facing the challenging tasks of obtaining approvals from the government. The results are yet to be seen.

To our knowledge no NPL's have been transferred to the AMCs since 2000. Indeed, certain AMC officials have recently been quoted in the press to be looking at acquiring additional NPLs, and so becoming possible competitors to the investment banks.

In the future, therefore, AMC's could become potential competitors instead of suppliers to foreign investors after they dispose of their remaining NPL's, although it is likely that the regulators would not welcome such competition and would establish rules and mechanisms to prevent it from occurring. It is almost certain that regulatory approval would be required on a case-by-case basis for such acquisitions, which are not within the AMCs current mandates.

Theoretically, under Article 3 of the PRC Commercial Banking Law, the banks can engage in any banking business with the requisite approvals from the PBOC (now exercised by the CBRC). On the buyer's end, if foreign investors wish to set up a joint venture in China to engage in financial business, they must obtain approvals from Ministry of Commerce and the CBRC or PBOC first. Although some foreign investors believed that the CBRC would liberalise disposal of NPLs, this has not yet happened. However, at the moment the government is still holding onto the approval system and scrutinising individual cases on a piecemeal basis.

Conclusion

Currently, foreign investors cannot directly acquire NPL's, rather they must do so through joint venture entities. The regulatory hurdle facing China's domestic banks in doing private deals with foreign investors is Article 43 of the Commercial Banking Law, which prohibits commercial banks from investing in non-banking financial institutions. This effectively precludes the commercial banks from being able to establish the joint venture entities necessary to do the deals.

There has been increasing pressure to resolve this issue, so as to permit these deals to go forward, because the quality of the assets remaining in the AMC's (which all pre-date 1997) is comparatively low compared to those NPL's held by the commercial banks. The banks would prefer to deal directly, rather than to sell through the intermediation of the AMC's. The revision of Article 43 is under consideration. According to recent reports, a draft revision of the Commercial Bank Law will be submitted to China's legislature later this month.

However, banks are already anticipating this change in regulation and are discretely evaluating debt recovery methods. For example, Baker Tilly Hong Kong recently opened a dialogue with a branch of a Mainland bank to assist it to dispose of its NPLs outside of an AMC structure and to work out such NPLs within a credit risk division of the bank, along the lines of a more international approach.

From a purely commercial point of view, it is also likely that the banks can achieve a higher price through a joint venture arrangement, providing some upside to the Chinese party and a pay out arrangement that satisfies their and the foreign investor's commercial objectives.

Prepared jointly by Rupert Purser and Thomas Jones. Dated 18 December 2003.

Rupert is the managing director of corporate finance and advisory at Baker Tilly Hong Kong and Thomas Jones is a senior partner at Freshfields Bruckhaus Deringer, resident in its Hong Kong office.