Recently a Morgan Stanley consortium and Goldman Sachs closed two landmark transactions in China - their respective purchases of $1.3 billion and $230 million in book value of non-performing loans (NPLs) from China Huarong Asset Management Corporation. This was the first successful international auction of an NPL portfolio in China. The transactions also mark the opening gun for foreign investment in China's distressed asset sector and are an important step in the reform of China's banking system.
China's NPL troubles began in the late 1980s, when the banks started to become the primary financing channel for the huge state enterprise sector. Before this, in China's central planning days, the government had been the primary financer of state enterprises, allocating budgetary funds directly to them. As China's economic reforms progressed and private savings grew to be substantial, bank deposits mushroomed and the banks took over the role of funding channel for state enterprises. Banks made a huge volume of loans to state enterprises, often at the direction of government policy-makers (so-called "policy loans"), and often to money losing companies with no prospect of repayment.
The banking system became the intermediary between the savers of China and the money losing state sector. Unfortunately, the banking system tended to ignore the most profitable sectors of the economy - private and foreign invested companies, who had to scramble for funds from outside the banking system. Instead, loans to the state sector piled up into a mountain of NPLs. Some economists estimated the total at $500 billion, or perhaps 30% of the total outstanding loans in the banking system. As economists would say, this was not an efficient allocation of resources.
Under this staggering burden, China's big four state owned banks (which hold 80% of deposits in China) were effectively insolvent. While they were clearly too big to fail, the issue clearly cast a pall on the credibility of the Chinese financial system. Sooner or later, the problem would need to be paid for, but by whom and at what price?
The irony here is that this mass of NPLs accumulated during the period of China's greatest economic prosperity in history - but NPLs are supposed to grow when the economy is bad, not when it is booming! What did this say about the management and competitiveness of the Chinese banks? With China's entry into the WTO approaching in 2001, and China's banks becoming subject to resulting international competition, Chinese policy-makers knew that something needed to be done.
The Chinese government formed four asset management companies (AMCs), one for each major state owned commercial bank, to take large pools of NPLs from its respective bank. In 1999, $150 billion in NPLs were transferred to the AMCs at book value, in exchange for 10-year bonds issued by the AMCs, backed by China's Ministry of Finance. The AMCs were now charged with disposing of this huge inventory of NPLs on the best terms possible. But China has no domestic institutional investors (other than the banking system) with pools of capital big enough to absorb such a large portfolios of assets, or with the management know how to pursue, resolve and administer such a mass of bad loans. That is why they needed the foreigners.
China Huarong Asset Management Corporation is the designated AMC for the Industrial and Commercial Bank of China, China's largest commercial bank. Huarong's CEO, Yang Kaisheng, aggressively solicited foreign capital to purchase Huarong's NPLs. He hired a specialist group at Ernst & Young to serve as Huarong's financial advisors, and they did a road show in the US. He also hired a major US law firm to help prepare international standard documentation. Extensive loan documentation files were prepared, transparent bidding procedures were established, information was distributed to bidders through the internet, and after extensive due diligence bids by the Morgan Stanley consortium and by Goldman Sachs prevailed in November of 2001.
Chinese government approvals for the Huarong transactions took longer than expected, and some began to doubt that the transaction would ever be completed. International economists had been watching the transaction with great interest as an indicator of how serious China was in resolving the sorry financial condition of its banking system. Some international investors doubted whether such transactions could be done in China without express authorizing legislation, given the difficult legal, regulatory and political issues presented.
Many of these doubts have been allayed. The Morgan Stanley deal was executed in a manner similar to international transactions of this type in other jurisdictions. We negotiated complex and thorough documentation, and the structure provided the foreign investors with control over the management and resolution of the assets. Other features of the transaction include international standard representations and warranties, acquisition financing and the obligation of the seller to cure or repurchase defective loans.
Much remains to be done however, before financial transactions of this type in China can become a part of ordinary course business. First, we believe transaction costs must be significantly reduced. Speedy government approvals and a reduction of China's burdensome asset transfer taxes would help a great deal to lower costs. Second, it needs to be better understood that specialized loan servicing companies are the international norm, so owners of NPLs often engage such companies to service the loans. Third, certain legal privileges that have been granted to AMCs to obviate third party consents and facilitate remedies should be extended to purchasers of NPLs as well.
China has a long way to go in resolving its NPL problems. The US$150 billion of bad loans transferred to the AMCs notwithstanding, the four state-owned banks still have over US$300 billion of NPLs. However, the Chinese government seems to have realized the importance of tackling the issue. A "financial security" group has been established recently within the top leadership, headed by Mr Wen Jiabao, China's new Premier. China has also established a new regulatory agency, the China Banking Regulatory Commission, to strengthen and discipline the banking system so that it will stop producing (or at least reduce production of) additional NPLs. After the Huarong transactions, many similar deals are expected to follow within the next few years, presenting more opportunities for international distressed asset investors.
