Non-performing loan resolution in China. (Journal of Real Estate Portfolio Management).

Executive Summary. China, like with other Asian countries, is closely following the approach used by the United States through the formation of the Resolution Trust Corporation (RTC) to resolve its non-performing loan problem. The purpose of this article is to review China's progress in attracting foreign investors to purchase the NPLs, and to evaluate a long list of factors that affect investor perceptions of uncertainty. These factors must be addressed before investors are likely to enter the Chinese market in force--a necessary requirement for the government to see higher NPL recovery rates and lower losses on loans made by the state-owned banks.

The article discusses three broad categories of uncertainty that affect investor perceptions about China's NPL market. Of these, it is in the area of execution that foreign investors face the greatest uncertainty. The government has been moving forward to resolve key issues with respect to repatriation of capital and tax rates for foreign buyers. Other issues depend more on what happens at the local level or on property-level negotiations such as laid-off employee liability. While these areas would benefit from strong national direction, only experience in resolving actual loans is likely to reduce investor uncertainty.

The success of the RTC in the United States hinged primarily on the speed with which NPL assets were brought to market and securitized. Investors responded creatively to the opportunity, and prices, which were initially low, rose quickly, thereby reducing the losses to the government. The Chinese government has attempted to apply the lessons of the RTC by creating four Asset Management Corporations (AMCs) to speed the loan resolution process, and by encouraging foreign investors to buy the NPL portfolios. Whether or not prices in China will rise rapidly as they did in the United States depends on whether foreign investors are able to get control of NPL assets quickly and to realize higher recovery values than they currently project, especially from loans originally made to the state-owned enterprises.

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China, like every other Asian economy, is dealing with a mountain of bad loans. The total clean-up cost is estimated by Standard & Poor's to be some $518 billion, or 43% of this year's gross domestic product (Business Week, 2002, p. 18). China has begun the long process of resolving its non-performing loan (NPL) problem by establishing four Asset Management Corporations (AMCs) to resolve some $169 billion of non-performing loans (NPLs) made to the four major state-owned policy banks. Resolution of the NPLs and recapitalization of its banks are of fundamental importance to China as it enters the World Trade Organization, and prepares its banks to compete head-on with Western banks. Toward this end, China is attempting to attract foreign investors to purchase the NPL portfolios.

The purpose of this article is to review China's progress in attracting capital to invest in its budding NPL market, and to evaluate a long list of factors that affect investor perceptions of uncertainty. These factors must be addressed before investors are likely to enter the Chinese market in force--a necessary requirement for the government to see higher NPL recovery rates and lower losses on loans made by the state-owned banks.

In establishing the four AMCs to work out the bad loans of the four major state-owned banks, China has closely followed the United States' experience with the Resolution Trust Corporation (RTC). The RTC's aggressive sales of NPLs has become a model for the rest of the world. Despite predictions of loan losses in excess of $400 billion, the final cost to the United States government was under $100 billion--one of the must successful government interventions into the U.S. financial markets.

To be sure, China has its own unique set of problems in dealing with its NFL situation. Unlike the United States, many of the loans are not real estate backed. Furthermore, many of the loans were made to state-owned enterprises (SOEs) that have assets of questionable value. Great uncertainty surrounds the ability of foreign investors to foreclose on delinquent loans and to collect much money from the sale of collateral. However, like the United States, China is using the NPL resolution process to introduce a new set of institutions into the market place. The success of the RTC depended on opportunity investors' bringing massive amounts of capital into the real estate markets and led to the first securitization of nonperforming loans. Similarly, China is looking to Wall Street and other global capital markets to resolve the NPL crisis through the first major foreign direct investments into Chinese financial markets.

The article has three main parts. It begins with a discussion of the RTC's experience in resolving the United States' NPL problem and a review of the literature on NPLs in Asia. The second part presents the NPL resolution process in China. This section begins with a brief discussion of China's banking system. It proceeds with a discussion of the classification and magnitude of China's NPLs, and ends with the government's approach to loan resolution by establishing the four AMCs. The third part evaluates fifteen factors that affect foreign investor perceptions about risk and uncertainty for investing in China's NPL market. The article concludes by highlighting the changes that must occur in order for prices on China's NPLs to rise--key to the government's objective for bringing in foreign investors to help reduce the ultimate cost of NFL resolution. The article's main contribution is to add to the literature about non-performing loan resolution--one of the most important financial restructuring issues througho ut the world over the last decade--and to illuminate the challenges facing China as it attempts to resolve its NPL problem.

PART I: BACKGROUND AND LITERATURE REVIEW

There are two strands of literature that are important for understanding China's NPL resolution process. The first strand describes the experience of the Resolution Trust Corporation (RTC) in the United States. The second strand relates to China's NFL problem and the fundamental financial restructuring that China's economy is undergoing. For both strands, the serious academic examination is only just beginning. Journal articles are sparse, so we have had to rely more than we would like on articles in the financial press.

The FDIC and the RTC Resolution Process

For understanding the RTC, two important compendiums of articles and forum discussions have been assembled by the Federal Deposit Insurance Corporation (FDIC). History of the Eighties: Lessons for the Future (FDIC, 1997) examines the formation of the RTC and the U.S. government's response to the banking crisis of the 1980s and early 1990s. A second two-volume publication by the RTC, Managing the crisis: the FDIC and RTC experience, 1980--1994, (FDIC, 1998) reviews the resolution methods and techniques used by the RTC during the Savings and Loan banking crisis and the RTC's performance.

The primary success of the U.S. resolution process was that despite the magnitude of the crisis, there were no serious bank runs or credit flow disruptions at federally insured institutions and, more importantly, no evidence of depositors losing their insured deposits (FDIC, 1998, v.1, p.6). In the resolution process, the FDIC performed its essential role as a deposit insurer of banks and savings associations and as a receiver. Its primary objective was to preserve the overall stability of the U.S. financial system and maintain public confidence. The RTC, on the other hand, had a narrower focus; its duty was to maximize net present value returns from the disposition of failed institutions and their assets.

One of the RTC's earliest challenges was to deal with the requirement of selling assets quickly without being accused of "dumping" them for prices that were considered to be too low. Initially, FIRREA (the Financial Institutions Reform, Recovery, and Enforcement Act of 1989) required that the RTC sell real estate for no less than 95% of its appraised (market) value. In 1991, however, in response to growing criticism of its slow sales and congressional concern over the cost of maintaining a rapidly growing inventory of properties, FIRREA was amended, and the minimum sales price was reduced to a stipulated figure of no less than 70% of the appraised value (FDIC, 1998, v.1, p.9).

Due to its limited life span, the RTC had neither the time nor the resources to develop an experienced staff, but by establishing working relationships and partnerships with large private asset management and disposition firms, it was able to acquire as much expertise in NFL resolution as it needed. It was also able to set up national sales centers and successfully sell assets in bulk.

Resolution of assets

Methods used by the RTC to dispose of assets previously owned by failed institutions include auctions and sealed bids, securitization, equity partnerships, and the use of asset management contractors. About $400 billion in assets were handled in one of these ways. Most of the RTC's assets were secured by real estate mortgages, and their disposition was further hampered by a nationwide decline in the real estate market. To meet this challenge, real estate-backed loan portfolios were stratified and placed in pools in accordance with such criteria as geographic area, asset type, asset quality, and asset maturity. In addition, the RTC also adopted the use of seller financing as a convenient tool for portfolio sales (FDIC, 1998, v.1,p.30).