DRAINING THE SWAMP
Beijing enlists foreign help with bad debt
Over the past six months, executives at the Hong Kong-based investment firm SC Lowy have been inundated with calls from bankers in China hoping to sell them distressed debt.
That is a first in the 11 years since the US$2-billion firm was established and underscores how China, after spending two decades trying to clean up bad debt by itself, is finally warming up to foreign capital.
The recent phase-one trade agreement with Washington paves the way for US financial services companies to apply for asset management licences that put them on par with their Chinese peers when it comes to buying distressed debt.
Once a licence is granted, US institutions can directly buy non-performing loan (NPL) portfolios from banks and bypass the Chinese companies that currently act as middlemen.
But the change comes with warnings from critics such as Republican Senator Marco Rubio, urging caution when it comes to buying soured Chinese loans.
“A majority of Chinese non-performing loans go to state-owned enterprises,” Rubio wrote last month in an opinion piece for The New York Times. “In the past, when a Chinese bank struggled with financing non-performing loans on its books, Beijing had to bail it out with Chinese money. But now, under this accord, American savings can do it.”
PricewaterhouseCoopers estimates China’s NPLs and other distressed assets at $1.5 trillion as of the end of 2019 and says the figure has yet to peak.
Foreign players such as Oaktree
Capital Management, Lone Star Funds, Goldman Sachs, Bain Capital, PAG and CarVal Investors have already moved into the market, and others such as Nomura Holdings and Deutsche Bank see it as an opportunity.
Savills Research, part of the UK-based property services group, said that purchases of bad-loan portfolios by foreign players nearly tripled in 2018 to 30 billion yuan from the previous year. That could increase further if investors can obtain more clarity on collateral management, pricing and legal recourse, analysts say.
“The local liquidity in China is clearly drying up,” said Soo Cheon Lee, chief investment officer of SC Lowy. “Over the last six months, we’ve received an increasing number of inquiries from brokers based in the mainland seeking our investment in distressed debt.
“This is a marked change for a market which over the past few years has tried to tackle the bad-debt challenge locally.”
That approach has only delayed and magnified the problem. Banks powered much of China’s economic expansion over the past few years, and regulators ignored loose lending as banks used the growth in loans to keep headline numbers in line with levels prescribed by regulators. But with a slowdown well under way and the coronavirus making things worse, the challenges are mounting.
For the first time in two decades, authorities last year had to intervene and bail out lenders, with Baoshang Bank, Bank of Jinzhou and Hengfeng Bank all needing help.
S&P Global Ratings said in a report late last month that more banks will need to be recapitalised, with China Bohai Bank, China Zheshang Bank and Shengjing Bank likely to come under more pressure.
To compound the situation, Chinese financial institutions established over the past 20 years — primarily with state support — simply do not have the capacity to keep a lid on bad debts.
Two decades ago, when banks’ bad debts stood at a fifth of all loans outstanding, China set up asset management companies in 1999 to swallow up the toxic assets.
What started as four centrally controlled asset management companies, or AMCs, has now mushroomed to 60. Most have been set up since 2015, after the Big Four struggled to take on the bad-debt explosion from the five-year debt binge that Beijing relied on to stimulate the economy.
Now, not even 60 are enough, and authorities were setting up another national asset management company. But economists are not convinced that is the answer.
“Opening a new AMC brings in capacity to the market at a time when NPL generation is surging and banks need to get rid of them,” said Sean Hung, senior analyst at Moody’s. “However, a new firm will lack the 20-year expertise and data the Big Four have garnered. That takes time to build up.”
A hedge fund analyst who monitors China’s banking sector said: “It’s just not that the banks are saddled with bad debt — the distressed debt market by itself is under duress.
“I put a high probability of one or more countrywide AMC licences — either new ones or national status — to be awarded to regional players. Still, that won’t be enough, and we need offshore funds to play a bigger role.”
Despite mounting bad debts, the rate of loan disposal by banks slowed last year, yet another indication of their inability to keep up the pace. They offloaded 2 trillion yuan ($287 billion) in soured assets in 2019, only a slight increase from a year earlier and compared with 1.4 trillion yuan in 2017, according to regulatory data.
The AMCs have branched out into banking, leasing, securities, futures, trust services, insurance and shadow banking to boost their income, but this too has caused trouble.
The expansion into shadow lending and other investments has meant the Big Four are “facing their own bad debt issues, while also being exceptionally overleveraged with an asset-to-equity ratio of more than 900%”, the hedge fund analyst said.
“They are thus incapable of buying large pools of bank NPLs. That kind of ratio is fine for a bank, but NPLs and excessive leverage go together like orange juice and toothpaste.”
What is more, the non-performing loans they bought over the past two years are largely from stressed regional lenders. Such loans and the investment products are “highly illiquid” and generally take two to three years to generate a cash flow. As such, there are questions over whether their 5-trillion-yuan balance sheets can meaningfully take on a bigger pile this year, the analyst said.
Chinese commercial banks held a total of 2.37 trillion yuan worth of NPLs as of September 2019, according to the China Banking and Insurance Regulatory Commission, up from 2 trillion nine months earlier.
Special-mention loans, or lending potentially at risk of becoming non-performing, totalled 3.8 trillion yuan, up from 3.4 trillion yuan at the end of 2018. NPL ratios for commercial banks ranged between 0.83% for foreign banks to 4% for rural banks. However, that is just the headline data, with the devil in the details.
Chinese commercial banks typically classify loans into normal, special-mention, substandard, doubtful and loss, and economists estimate the declared soured loan ratio is not reflective of reality. On an internationally comparable basis, analysts estimate the measure could be 6% on a conservative basis, with some putting the marker back at the 1997 high of 20%.
Chinese banks are not as resilient as the numbers suggest, and some will require “sizable” recapitalisation, S&P said in its report. Its findings were based on an analysis of stress tests carried out last year by the People’s Bank of China on 30 of the country’s largest banks, each with assets of at least 800 billion yuan.
S&P said China’s NPLs remain highly sensitive to economic growth, even for sizable banks. As a result, the financial system remains vulnerable to a slowdown in the economy, contagion and idiosyncratic risks, it said.
Authorities are aware of the magnitude of the challenge, and that is why they are opening up the market to Wall Street, analysts say.
Sensing an opportunity, firms such as Bain Capital are setting up credit funds. Nomura Holdings over the past two years has steadily built up its China investment team to tap the markets.
So far, foreigners have focused on distressed debt backed by properties, including hotels, warehouses and other commercial or residential buildings. They buy loans at a 30% to 50% discount, with the aim of making a return of as much as 20% by selling the real estate. The portfolio aspirations are now changing.
“After a long wait and several false starts over the years, banks and funds believe the time is now,” an investment specialist at a global bank said. “Yields on all NPLs are attractive — so is the risk, though. But it is time to move in as Chinese are also acknowledging they need the due diligence foreign capital applies.”
“The local liquidity in China is clearly drying up. … We’ve received an increasing number of inquiries from brokers based in the mainland seeking our investment in distressed debt”
SOO CHEON LEE
Chief investment officer, SC Lowy