[China] Credit squeeze risks triggering loans crisis
Elliot Wilson
The mainland's long-running banking crisis may get worse before it gets better - thanks to its own attempts to rein in an economic boom that threatened to get out of hand.
A wave of new non-performing loans (NPLs) could soon hit China's biggest banks as the government's credit squeeze triggers defaults by everyone from steel mill owners and car buyers to golf course developers and homeowners.
New lending this year by China's biggest banks outpaced even last year's record figures to the acute discomfort of policy-makers in Beijing.
The ``Big Four' state-owned lenders, which include Bank of China and China Construction Bank (CCB), made 670 billion yuan (HK$631.7 billion) in new loans in the first six months of this year, up 20 billion yuan from last year, according to the China Banking Regulatory Commission.
Figures from the People's Bank of China (PBOC) show loan growth slowed slightly in June, but still rose 13.9 per cent year on year, following a record 23.2 per cent annualised increase in June last year.
Central bankers first began to worry publicly the economy was spinning out of control in March, when the PBOC announced total outstanding loans grew 2.2 per cent on a monthly basis and 20.1 per cent year on year.
Even with government attempts to rein in some of the most overheated parts of the economy, including real estate and steel, new lending by the big four this year could exceed last year's record 1.3 trillion yuan. And commercial loan growth that year was 18-20 per cent, one of the fastest rates of growth in the world, according to accountants Ernst & Young.
More troubling than even this pace of new lending is the areas where the money flowed - many analysts reckon it went to the so-called ``bubble sectors' - real estate, autos, and natural resources such as aluminium and steel - the very areas where loan defaults look most likely.
``Loan growth has basically doubled in three years, and in my view in any market with extraordinary growth in a short period of time there's usually a problem that follows,' said Jack Rodman, managing director of Ernst & Young Asia Pacific Financial Solutions and adviser to Huarong - one of the four asset management companies (AMCs) set up in 1999 to clean up China's banking system.
Some hint at the dimensions of the problem: Total aggregate lending by all Chinese banks reached 18.48 trillion yuan at the end of June, more than double the total outstanding loans at the end of 2001.
At the individual bank level the situation is just as worrisome. Outstanding loans at Merchants Bank, the most respected of China's five listed lenders, rose 30 per cent by the end of June from a year ago. Minsheng Bank, the country's first private lender, saw outstanding loans rise 24 per cent year-on-year at the end of last year.
Soaring first half profits at Pudong Bank and tiny Huaxia Bank were driven by new lending, both banks said, with only HSBC's new mainland partner, Bank of Communications (BoCom), announcing a drop in new first half loans.
``You could argue that a lot of the loan growth is good - well, I think a lot of it is real estate and there are clearly concerns of a real estate bubble,' Rodman said.
Even at BoCom, however, there must be concerns at future bad loans emerging - last year, according to its annual report, real estate benefited more from incremental loans than any other sector, receiving 11 per cent of all new lending.
``I'm sure there are a lot of bad loans being created right now,' said Yi Zhang, a partner at law firm O'Melveny & Myers in Hong Kong, and lead counsel for Morgan Stanley last year during the sale of 10.8 billion yuan worth of bad loans from Huarong. ``NPLs are going to be a long-term problem for China.'
Beijing policy-makers are acutely aware of the challenges facing the banking system and those who regulate it. But their efforts to cope with the problem have been faltering at best.
In the forefront are the AMCs - Cinda, Huarong, Orient and Great Wall. They were set up in 1999 to clear up all the bad debt created by the big four banks before 1995. The year they were established, Beijing identified 1.4 trillion yuan in bad loans - or roughly 17 per cent of the then GDP of China - at the big four lenders. They then transferred them to the AMCs at book value - ensuring that the banks did not incur further losses that would have severely drained their capital base.
By the end of last year, the four had disposed of US$62 billion (HK$483.6 billion) of the original tranche of assets, leaving US$107 billion on their books.
But with the AMCs absorbing all transactional expenses, the cost of the bonds issued to the big four banks when they acquired the sour assets as well as an NPL recovery rate of around 20 cents on the dollar, it has been a very costly process.
Assets with a face value of just US$2 billion had been sold to investors by the end of last year, with the rest disposed of in return for cash settlements, property, or pledges of assets or stocks.
The basic job of the four AMCs was similar to that of agencies such as the Resolution Trust Corporation, which the United States created to sort out a savings and loan debacle. They were expected to sift through the rubble, sorting out the good and selling off the bad assets - in the form of everything from half-completed shopping malls in Inner Mongolia to bankrupt office buildings in Shanghai - to domestic and foreign investors, allowing the Ministry of Finance and the PBOC to recoup some their losses.
The big sell-off has been mostly a non-event, though not so much for want of would-be buyers. The four AMCs have been tardy in valuing and auctioning off state assets, in large part due to the government's fear of selling them off on the cheap - especially to foreigners.
Domestic and foreign investors, mostly represented by the big international investment banks, are keen to snap up sour loans at below-market prices - but have become frustrated by repeated delays, rule changes and red tape.
Just US$500 million in bad loans have been sold so far to domestic and foreign investors - mostly by two separate asset sales by Huarong.
One of the toughest challenges may be that facing Cinda, the AMC partner of CCB, which in June paid 31 cents on the dollar for bad loans with a face value of 278.7 billion yuan from Bank of China and CCB.
The deal requires Cinda not only to make a profit on the loans - recouping at least 33 per cent of the value, assuming transaction costs add a couple of percentage points - but to sell all the loans within 18 months. Quite a task for even a crack asset-disposal team - and one many people believe is beyond Cinda's grasp.
``Cinda needs to recover US$10 billion to US$11 billion in bad loans when the entire market has only raised US$500 million,' said a mainland specialist on NPLs, who declined to be named.
``The Huarong transactions have been for around US$2 billion in face value, and have taken 90 days for due diligence and 90 days for investors to underwrite them.'
Even if Cinda hopes to to recoup half these loans, ``it would need to go to the market every 90 days with that size of transaction - a Herculean effort', he added. ``Cinda should look to the Korean Asset Management Corporation, deemed the most successful AMC in Asia, which moved billions of [US] dollars in NPLs in a short time through an aggressive marketing programme to domestic and international investors.'
Even after due diligence and underwriting are complete, however, there are further delays in closing the deal. It took 14 months for Huarong to receive regulatory approval to complete its first major asset disposal.
A second tranche, bid last December, was recently closed for domestic investors but not for investment banks Lehman Brothers, Goldman Sachs, UBS, JP Morgan and Citigroup. Each still awaits regulatory approval to establish investment vehicles in China, in order to receive assets from Huarong.
The question now for Beijing is whether it can provide its AMCs with enough incentive to act quicker - and assurance that their valuation of assets will not be questioned by the party. AMC officials have constantly been second-guessed by government cadres either coveting a party promotion or bitter at the perceived underpricing of state assets.
Many believe the central government needs to appoint a powerful individual to oversee the NPL clean-up - as has happened in Japan, Korea and Taiwan, all places similarly saddled with bad loans. ``Ultimately there is no one at the top saying `do it, get it done, get it done quickly and don't concentrate on making a profit, just maximise the recovery value',' Rodman said.
``You need someone higher up than [China Banking Regulatory Commission chief] Liu Mingkang or [central bank governor] Zhou Xiaochuan to come and say `do it',' O'Melveny & Myers' Yi said. ``There are indications that the government is accelerating the NPL resolution process, though they don't have a lot of time.'
Time is fleeting, particularly with a full opening of China's banking sector to international competition on the horizon, and with the country still host to the largest batch of NPLs in the world after Japan.
After years of foot-dragging and political interference, Japan is finally moving to clear its books of bad loans, while China has barely begun. The frustration among would-be buyers is palpable.
``China should be competing with Japan to clear up its NPLs, but if it doesn't clear up its system, foreigners may start to say this is taking too long and may go elsewhere,' Yi said. ``[The authorities] don't realise this, but it's a definite possibility.'
