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Weekly UpdatesIn June 1998, the PBOC ordered the Hainan Development Bank (HDB) in Hainan Province to be closed. This was the first bank failure since the establishment of the People's Republic of China (PRC), and it signaled the end of the myth that "China's banks never fail." Immediately before HDB's failure, there was a run on the bank, the first instance of a run on a PRC bank triggered by worries about its credit. This demonstrated that the stability of the credit system, which had been maintained by the commitment of central and local governments, was changing: it indicated that Chinese banks were now exposed to much greater liquidity risks. To avoid a liquidity crisis within the financial system, the government injected 270 million RMB into the "Big Four" in 1998.
Classification and magnitude of NPLs
The PBOC, the central bank of China, required commercial banks to introduce a newly defined five-category asset classification system in 1998, which is modeled on the United States' system (Figure 1).
The system is set forth in the Guiding Principles on Lending Risk Classification issued by the PBOC. Although these guiding principles detail the criteria that should be used in loan classification, the system for monitoring loan performance in China remains substandard. Chinese banks do not appear to adequately grade the quality of their loan assets and, when compared to international banks, it can be seen that they understate their NPLs. Although the PBOC announced that 25% of all its loans are NPLs, S&P estimates that the NPLs may account for up to 50% of all lending done by the four big state-owned banks. They claim that even in the Bank of China, the best of the "Big Four," NPLs account for 39% of the banks loan portfolio.
Government Approach to NPL resolution and establishment of the AMCs
Government involvement in NPL resolutions in China has taken various forms. From the mid-1990s, the government began to separate commercial lending from policy lending. It established three policy banks to handle all policy-related lending, in the hopes that wasteful lending to failing companies from the four commercial banks would decline and that internal and external competition would intensify within them. Since Prime Minister Zhu Rongji took control of the financial reform, a number of reform measures have been put forward to deal with NPLs and to guard against risks in the banking system. These included (1) injecting equity to recapitalize state-owned banks; (2) compelling banks to adopt international standards when classifying NPLs; (3) requiring banks to make loans on a commercial basis; (4) for-bidding local governments to interfere with the lending decision of banks; (5) creation of four Asset Management Corporations (AMCs) to take over and liquidate the NPLs from the "Big Four" state-owned banks; a nd (6) debt to equity swaps.
The AMCs in China are largely based on the RTC model successfully used in the U.S.. They are government-sponsored agencies with limited life (10-year). China's four AMCs are responsible for the disposal of approximately 1.3 trillion-RMB (US$169 billion) in NPLs injected into them from the four State commercial banks. NPLs in the four AMCs consist largely of corporate loans to SOEs. Among these, it is estimated that around 25% to 30% are real estate loans. Outside of the AMCs, another $220 billion in NPLs are estimated to be held by other banks. This figure excludes bad loan holdings by large SOEs, insurance companies, and non-bank financial institutions.
Cinda, the first AMC in China, was established in April, 1999, after the State Council's decision to experiment with the disposal of NPLs. Cinda received 373 billion-RMB (book value) as a lump sum financial asset transfer from the China Construction Bank and the State Development Bank. Most of these assets were in the form of loans to key capital construction projects and large-scale state-owned enterprises, with 203.8 billion RMB concentrated in 1,050 enterprises. Cinda's assets were also largely concentrated in basic industries, among which 16.1% (61.2 billion RMB) were in the energy industry, 13.1% (50 billion RMB) in real estate, 6.2% (23.5 billion RMB) in the metallurgical industry, and 5.4% (20.5 billion RMB) in the construction material industry. Loans in the amount of some 144 billion RMB (40.8%) were concentrated in the developed Eastern region.
Technically, Cinda assumed only that portion of NPLs which had been incurred prior to 1996. NPLs incurred after 1996 stayed on the China Construction Bank's balance sheet and were categorized as results of the bank's own mismanagement and not the result of government policies. Loans deemed irrecoverable (i.e. recognized loan losses) were also not transferred to Cinda instead, they were written off by the government.
Following Cinda, three other AMCs were established in 1999. These were the Huarong AMC, the Great Wall AMC, and the China Orient AMC. In terms of their legal status, the four AMCs are wholly state-owned, non-bank financial institutions under the supervision of the Ministry of Finance (MOF) and the PBOC. Each of them had/has registered capital of RMB 10 billion (approximately US$1.2 billion) and was/is directly funded by the MOF. In 2000, to finance the purchase of the commercial banks' assets that had been transferred to them, each AMC issued ten-year bonds, guaranteed by the MOF, to their respective "partner" in the Big Four. Cinda purchased assets valued at RMB 375 billion; the Great Wall purchased RMB 345 billion in assets; China Orient acquired assets valued at RMB 264 billion; and Huarong bought assets valued at RMB 407 billion.
Under applicable law, the four AMCs are authorized to deal with all three types of assets: debt, equity and real property. By far the largest proportion of the AMC assets are comprised of unconverted debt in the form of NPLs. Most of these NPLs are unsecured. A comparatively small proportion of the debt now held by the AMCs is secured by physical collateral or pledges. The equity of SOEs that the AMCs hold is the result of debtto-equity swaps.
By July 2002, China's four asset-management companies (AMCs) had disposed of 210.36 billion RMB (US$25.4 billion) in nonperforming loans (NPLs) and recovered 45.45 billion RMB (US$5.5 billion) in cash. The recovered cash accounted for 21.6 percent of the face value of the NPLs that were disposed. Within slightly more than two years since the four AMCs were established, Huarong has disposed of 38.85 billion RMB (US$4.7 billion) in NPLs and recovered 12.426 billion RMB (US$1.5 billion) in cash (31.98%). China Great Wall has disposed of 76.04 billion RMB (US$9.2 billion) in NPLs and recovered 6.6 billion RMB (US$793.4 million) in cash (8.64%). China Orient has disposed of 31.96 billion RMB (US$3.9 billion) in NPLs and recovered 7.41 billion RMB (US$895.2 million) cash, accounting (23.19%). China Cinda has disposed of 63.5 billion RMB (US$7.7 billion) in NPLs and recovered 19.04 billion RMB (US$2.3 billion) in cash (29.98%).
Attracting foreign capital to help resolve China's NPLs and raise the recovery rates has become a principle objective of the government. Following the successful experience of the RTC in auctioning off NPL assets in the United States, China Huarong AMC carried out the first auction to foreign investors in November 2001. The cover story of the February 2002 edition of EuroMoney Magazine was the first to offer an in-depth report on the auction process and to discuss the opinions of the various foreign investors and government officials regarding the value of the NPLs being auctioned. As the article points out, the pricing of these non-performing assets is extraordinarily difficult. In fact, there are so many unknowns that a number of the parties involved consider the available assets to be worthless: "We used the normal criteria we use elsewhere but we just couldn't compute a value." There are others, however, who still think the assets are investment-worthy.
Among the divergent opinions, there remains a single consensus that the involvement of foreign investors will help China to speed up the disposal process and improve its rate of recovery as measured by the ratio of sales proceeds to outstanding principal balance (OPB). The estimated recovery rate for the Huarong auction was about 22%, according to an insider foreign financial adviser. This figure is much higher than the average existing recovery rate under the present bankruptcy laws (less than 10%). The target recovery rate for the four AMCs has been set at 30% of the total value of all of the outstanding loans that have been taken from China's four major commercial banks.
PART III: FACTORS AFFECTING FOREIGN INVESTOR'S PERCEPTIONS OF UNCERTAINTY ABOUT CHINA'S NPL MARKET
While the bids by foreign investors in the first auction for NPLs by China Huarong AMC were higher than the other current recovery rates, they were still below the target recovery rate set by the government. The low pricing was largely due to the presence of many loans by SOEs. Uncertainty relating to whether foreign investors will be able to get control of the underlying assets of the SOEs, and the value of those assets if and when they do so, have caused the foreign investors to give little value to the SOE assets.
While China has taken a number of critical steps to deal with its NPL problem, many of the rules and regulations necessary to resolve the NPLs are just now being passed. Although the opportunities are enormous, foreign investors have demonstrated considerable reluctance to plunge into China's NPL market. This reluctance reflects the uncertainty that investors have about their ability to resolve NPLs, convert them to cash, and repatriate the proceeds in a timely manner. The speed with which investors can accomplish the various steps necessary to take control of assets used as collateral for NPLs directly affects their willingness to pay more money for the NPLs--a principal objective of the Chinese government, and a necessary condition for reducing the losses associated with NPLs. (1)
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