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Author: Philip B Gilligan
Service Area: Insolvency & Restructuring
Date: May 2005
Country: Hong Kong

 

China NPLs: Trends and Future Issues

SUMMARY OF CONTENTS

programme overview

The Chinese government estimated that the non-performing loan (NPL) ratio for major commercial banks in China, including the four wholly state-owned commercial banks (Bank of China, China Construction Bank, Industrial and Commercial Bank of China and Agricultural Bank of China), amounted to RMB 1.7 trillion (US$240.7 billion) or 13.2% at the end of September 2004, down 4.6% over the year. Bank of China separately reported an NPL ratio of 4.55% as of October 2004, down from 5.16% at the end of September 2004 and 16.3% at the beginning of the year. China Construction Bank reported an NPL ratio of 3.74% at the end of September 2004, the lowest among the big-four state banks.

However, private estimates are much higher. The difference in the NPL estimates could be due to different methods of calculation or subjectivity of the evaluators, and the official figures have in any event been flattered both by significant one-off transfers from the banks of bad loans and an increase in overall lending.

But the origin of this dauntingly high level of NPLs is certain. It is a result of over 40 years of extensive policy lending under a centrally planned economy, and the banks still remain subject to government control and direction.

Unfortunately, the big-four do not have decades to resolve this historic NPL problem. By 2007, China will complete its full integration into the WTO. At that time, the country's banking market will open to foreign competitors and the big-four will be subject to full market competition. It is therefore essential to restructure the big-four and clear up their balance sheets in order to ensure their continued solvency and their future listings on overseas stock markets.

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AMCs

In response, the Ministry of Finance [herein MOF] set up four asset management companies [herein AMCs] in 1999, one for each wholly state-owned commercial bank. Thus, Cinda (for China Construction Bank), Huarong (for Industrial and Commercial Bank of China), China Orient (for Bank of China) and Great Wall (for Agricultural Bank of China) came into being. The main purpose of these AMCs was to acquire the banks' NPLs at book value - hence separate the bad bank (AMCs with the NPLs) from the good bank (the big-four with ongoing operations and performing loans).

In 1999, the State Council ruled that the AMCs would acquire RMB 1.39 trillion of NPLs from the banks at book value without discount. The purchase was made in part by cash (lent to the AMCs by the People's Bank of China [herein PBOC], China's central bank) and in part by bonds issued by the AMCs to the banks. The partial use of debt to pay for the loans meant that the banks were still exposed to AMC credit risks (equivalent to the original NPL exposure). To address this, the PBOC was required to guarantee the AMC bonds; thereby the credit risk was passed to the PBOC. Since the MOF owns the AMCs, the banks and the PBOC, there was no net cost incurred to the State in providing such backing. The arrangement effectively passed the credit risk of the NPLs from the banks to the PBOC, via the AMCs. The end result is, of course, a dramatic strengthening of the balance sheets of the banks.

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DEVELOPMENT OF AMCs

Over time, the role of the AMCs has developed, so they are now not rigidly tied to one particular bank and recently, for example, have been competing between themselves (but not with third parties) to purchase NPLs from China Construction Bank and Bank of China in preparation for the banks' proposed listing. In June 2004, Cinda beat the other three AMCs to purchase a combined RMB 280 billion (US$34 billion) of distressed assets from China Construction Bank and Bank of China. In December 2004, China Orient agreed to purchase RMB 130 billion (US$15.6 billion) of the China Construction Bank portion of the portfolio from Cinda. ICBC is inviting the AMCs to bid on loans with a face amount of approximately US$54.4 billion equivalent, although this time the loans may be divided into separate pools unlike with the China Construction Bank/Bank of China sale where there was a single asset pool.

The original life of the AMCs was to be 10 years, but this is now being extended along with changes to function on more of a commercial basis. In this regard, the AMCs are additionally becoming involved in taking over failing securities brokerages and Huarong has even received the certificate of ISO9001:2000 from the British Standards Institution. It is possible the AMCs will evolve into financial holding companies, involved in asset management as well as corporate and investment banking. It is also possible the stronger AMCs may merge with the weaker ones.

As at the end of March 2005, Huarong, Great Wall, China Orient and Cinda had resolved RMB 214.44 billion, RMB 213.61 billion, RMB 106.79 billion and RMB 153.71 billion worth of NPL assets, respectively, recovering RMB 42.57 billion (19.85%), RMB 22.24 billion (10.41%), RMB 24.37 billion (22.82%) and RMB 51.71 billion (33.64%), respectively.

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AMC AUTHORISED ACTIVITIES

In purchasing NPLs from a state-owned bank, the business scope of an AMC encompasses the following:

  • debt collection; 
  • the leasing, transfer or restructuring of assets comprising the NPLs purchased; 
  • debt equity swap, and the temporary holding of shares of corporations; 
  • sponsorship in the listing of, and underwriting bonds and stocks for, companies falling within its scope of asset management; 
  • bond issuance and borrowing from financial institutions; 
  • providing financial and legal advice, asset and project valuations; 
  • all other activities as approved by the China Banking Regulatory Commission (CBRC) and the China Securities Regulatory Commission (CSRC).

As noted, an AMC can swap the debt interest with an equity interest in the corporate borrower of the NPL. Such equity interest held by an AMC will not be subject to the requirements on the net asset amount or the registered capital ratio of the corporate borrower. After the debt equity swap, an AMC may, as shareholder of the corporate borrower, nominate representatives to take part in board meetings and supervisors' meetings, and exercise other rights of a shareholder. An AMC can also assign its equity interests in a corporate borrower, or sell the equity interests back to the corporate borrower.

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AMC FOREIGN EXCHANGE ACTIVITIES

In the purchase of NPLs, an AMC may engage in the following activities involving foreign exchange:

  1. the purchase of nonperforming foreign exchange assets disposed of by the respective state-owned commercial bank; 
  2. the exchange, transfer or sale of foreign exchange assets and foreign debt collection; 
  3. the restructuring of foreign debt obligations; 
  4. foreign debt equity swaps and temporary shareholding; 
  5. and all other businesses approved by the CBRC relating to the taking on of nonperforming foreign exchange assets.

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RESTRUCTURING, DEBT COLLECTION AND DISPOSAL OF ASSETS

In order to attract foreign capital in buying and restructuring the NPL assets, the Ministry of Commerce (former MOFTEC), MOF and PBOC jointly promulgated the "Absorption of Foreign Capital by Financial Asset Management Companies to Participate in Asset Restructuring and Disposal Tentative Provisions" on October 26, 2001 [herein 2001 AMC Decree].

Article 6 of the 2001 AMC Decree authorises an AMC to absorb foreign capital under any of the following circumstances:

  1. the selling or transfer of equity or debt interests in nonlisted companies after restructuring of the same by the AMC; 
  2. the direct sale or transfer of equity and debt interests in nonlisted companies to foreign investors; 
  3. the sale of tangible assets by way of transfer, tendering or auction, etc.; and 
  4. the setting up of a foreign invested enterprise in collaboration with a foreign investor by the injection of equity interests and tangible assets of the original corporate borrower.

The 2001 AMC Decree also provides that asset valuation reports should be compiled before an AMC sells or transfers restructured assets.

In order to facilitate the AMCs to collect debts through court proceedings, the Supreme People's Court issued a specific notice on April 3, 2001 (which took effect on April 23, 2001) according AMC's special legal status in the following circumstances:

  1. While a branch of an ordinary company does not have locus standi to appear before courts in the PRC, a branch of an AMC is given such standing by virtue of the Supreme Court notice.
  2. According to Article 80 of the PRC Contract Law, an assignment will not take effect unless and until the creditor has notified the debtor of the assignment. The Supreme Court notice provides that a public announcement in a national or provincial newspaper made by an AMC will be deemed to be proper notice to debtors of the transfer of the loan to the AMC.
  3. In order to enforce a court order, a plaintiff may apply for an interim order for preservation of property (similar to a Mareva injunction) in accordance with the Civil Procedure Law. However, the court usually requires the plaintiff to provide security equivalent in value to the property sought to be frozen. The Supreme Court notice has in effect dispensed with such a requirement when an AMC applies for such an order.

In November 2004, changes were made to attempt to speed up the transfer of NPLs to foreign investors. AMCs are to report proposed sales to the Development Reform Commission within 30 days of agreement, and the Commission is to respond within 20 working days. In December 2004, it was announced that details of transactions must be submitted to SAFE within 15 working days of completion. Since January 2005, foreign investors have been permitted to remit out of China funds related to NPL disposals, subject to reporting transaction details to SAFE.

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FOREIGN INVESTMENT

Various attempts have been made to attract foreign investment in these restructured assets. In November 2001, Huarong signed a landmark agreement to sell RMB 10.8 billion worth of NPL assets to a consortium led by Morgan Stanley, which agreed to pay Huarong in cash about 9% of the face value of the loans. In December 2001, Huarong sold a second tranche of RMB 1.97 billion worth of NPL assets to Goldman Sachs. Goldman Sachs successfully structured and executed the first joint venture in China, Rongsheng Asset Management Co., to own and operate an NPL Servicing Company to resolve the loans. Shortly after that, the joint venture between Huarong and the Morgan Stanley Consortium, First United Asset Management Corporation was established. The Goldman Sachs and the Morgan Stanley transactions received government approvals in February and March 2003, respectively.

Separately, in December 2001, China Orient arranged the sale of a US$217 million NPL portfolio to the US-based Chenery Associates. The transaction involved a complete sale of the portfolio from China Orient to Chenery Associates for a consideration of US$21 million payable in cash on completion, which is about 10% of the face value of the loans. As part of the structure, the financial advisor to China Orient, PricewaterhouseCoopers, was also appointed to service the NPLs portfolio, and in turn retained China Orient to assist in the process of assets recovery. As a result, China Orient was entitled to claim a success fee equivalent to approximately 50% of all realisations above a certain threshold.

In 2003 and 2004, further deals came into the market as the AMCs geared up foreign investors initiatives. China Construction Bank moved forward with a portfolio sale of NPLs to Morgan Stanley but ran into approval problems, not least as the deal envisaged a direct sale by the bank and the sale of loans at below book value. China Construction Bank also undertook a sale of "settled assets" to foreign investors, i.e., the assets securing the loans, thereby circumventing various regulatory restrictions, with Morgan Stanley and Deutsche Bank the successful bidders.

Another significant deal in 2003/2004 was the auction sale of Huraong's RMB 22.5 billion worth of NPL assets. The winning bidders included Citigroup, JP Morgan, Goldman Sachs, UBS, Morgan Stanley, Lehman Brothers and at least one Chinese company. Of the 22 portfolios on offer, only three were won outright with another 14 being acquired after further negotiation. The remaining five portfolios were withdrawn as the bid prices were too low.

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FURTHER DEVELOPMENTS

A number of private deals are ongoing. For example, Citigroup has agreed to buy a portfolio with a face value of RMB 2 billion from China Great Wall Asset Management. This transaction takes the form of an outright sale, rather than a joint venture as was usually the case with Huarong.

Transactions also seem to be getting bigger. In December 2004, Great Wall invited bids for assets valued at US$18.1 billion, more than four times the total sold so far to foreign investors. Cinda is currently planning to offer RMB 21.5 billion of NPLs to both domestic and foreign investors, but with only two portfolios really aimed at foreign investors.

Both Cinda and Huarong have begun to assess the use of securitisation to dispose of their NPL portfolios. Cinda has engaged Deutsche Bank as its advisor to issue bonds to overseas investors and Huarong has signed a similar co-operation agreement with Korean Asset Management Corporation.

As an alternative method of investment, Citigroup in 2004 took a 16.4% stake in Silver Grant International Industries, a Hong Kong-listed affiliate of Cinda charged with acquiring and managing NPLs.

Specialist, well funded and well connected institutions such as FDC Fengde Capital are playing an increasingly important role in the NPL market.

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This technical briefing is an amended version of chapter 4.01[1][c][i] of "Banking Regulation in China" by Philip B. Gilligan, forming part of Gruson & Reisner's "Regulation of Foreign Banks" published by LexisNexis in the US in 2005. Whilst every effort has been made to ensure the accuracy of this publication, it is intended to provide general guidance and not definitive legal advice.