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Weekly UpdatesThere are three broad areas that affect investors' uncertainty and reluctance to plunge in the Chinese NPL market:
A. Political and social will to get the job done
B. Legal environment
C. Execution
Below we assess fifteen different factors that must be in place if China is to succeed in attracting significant foreign investment in NPLs at prices and recovery rates that they hope to achieve.
A. Political and social will to get the job done
1. National level. There is general agreement that China's leaders have been aggressive in tackling the need to perform major financial restructuring. Under Prime Minister Zhu Rong Ji (1992-present), the government recognized the NPL problem before it became a major crisis. (2) The government has demonstrated its commitment to change by establishing the AMCs and by having the four major state-owned banks sell loans to them. They passed rules that tackled fundamental issues such as letting foreigners own leasehold interests and repatriate their capital. So far, the central government's will to get the job done seems to have been strong.
2. Local Level. While China has done the structural work to set up the AMCs, it is unclear whether they have the political and social will to push deals through the system. The problem is that politics are very local, arid the national government has less authority than most Americans assume to command local politicians to carry out their policies. While the national government has demonstrated its will to get the job done, it has not been proven yet whether they will be able to force local politicians to go along with the hard decisions that must be made. Will local politicians, for example, allow foreigners to take over and close down local factories, putting a lot of people who supported the local party officials out of work?
3. New leadership. The other big political unknown is what the new leadership will do. Will they take the same aggressive stance in support of financial reform as the previous leadership did, or will they bow to pressures as in Japan to go more slowly with financial restructuring?
4. Social security. Fear of social upheaval make China's national government ambivalent about giving foreign investors full reign to take action against SOEs that may cause people to lose their jobs. SOEs have provided many aspects of social security, including housing, and education for workers and their families. As SOEs are restructured or closed, the social services that they provided must be replaced by a broader social security system that has yet to be fully developed. The absence of a safety net increases investor concerns that the political will to get the job done will fade quickly if foreclosures by foreigners lead to even hints of social unrest.
B. Legal environment
In order for a market in NPLs to flourish, the legal framework must provide for foreclosure, orderly bankruptcy resolution, established creditor rights, and ownership rights for foreign investors.
5. Foreclosure laws. The foreclosure laws in China are similar to those in the United States. They give creditors all the powers they need to foreclose on debtors for non-payment of loans and to go after their assets. Creditor are allowed under the law to (i) institute civil proceedings and enforcement against the debtor and/or guarantor and their assets; (ii) realize the value of collateral through sale at auction or agreement or by transfer of the creditors' rights; (iii) realize creditors' rights through negotiation with debtors and guarantors to restructure the enterprise; (iv) to petition for bankruptcy of the debtor or guarantor; and (v) to go to court to foreclose where no agreement is reached between the creditor and debtors. The court will decide whether the mortgaged property will be auctioned or sold.
6. Bankruptcy laws. Bankruptcy laws also operate in a similar manner to those in the United States, both for private enterprises and SOEs. Upon petition for bankruptcy, which may be initiated by the creditor, the debtor is required to submit a plan of reorganization after the creditors and the court have approved the plan of reorganization. The SOE has up to two years to complete the reorganization, which can be terminated by court order sooner if the debtor's financial situation deteriorates or if he fails to implement the settlement plan.
7. Creditor rights. Priority of creditors-rights are well-established. Protection of secured creditors and payment of liens is enforced in the order in which the loans were registered. (3) Collateral includes land-use rights, buildings, machinery and equipment, and transportation vehicles. Mortgages of all these forms of property are permissible under PRC Security Law. The four state-owned banks have been actively working their NPL portfolios to resolve as many loans as possible. Foreclosure and bankruptcy laws and processes as well as creditor's rights seem to be functioning in a similar manner to those in the United States, although they have not been tested yet by foreign investors.
8. Foreign investor rights and ownership. All private property ownership is in the form of leasehold interests ranging from 50 to 70 years depending on the land use. Foreign investors are able to assume the leasehold rights on property. More complicated are restrictions on foreign ownership in certain industries including financial institutions. A complex set of legal entities and special joint ventures has been established to deal with servicing issues on the Morgan Stanley consortium that purchased the first China Huarong portfolio. They have established the first foreign-owned independent company for holding and servicing the NPLs for their disposition (Yang, 2002). Receiving government approvals for these unique arrangements has taken much more time than originally anticipated, but such approvals are now in place, opening the way for similar arrangements by other purchasers in the future.
C. Execution
The third area, execution, presents the greatest uncertainty for NFL resolution because there simply has not been enough experience yet in China to see if the process of NFL resolution will go smoothly. Some areas are clearer than others in terms of having rules in place or tested. For space reasons, the list below emphasizes only the highlights.
9. Court enforcement. Court enforcement is the ultimate weapon that investors have to force borrowers to pay up or hand over collateral quickly. How local courts will treat foreign investors as they attempt to exercise their creditor rights is untested. Will local courts enforce the laws regarding foreclosure and bankruptcy? The vast majority of borrowers are SOEs or joint ventures with SOEs. Will the courts enforce laws that lead to closure of local factories, especially where the general manager of the factory may be related to the judge? Considerable uncertainty surrounds the interpretation of legal processes and how local courts will behave. Although the central government supports enforcement of the laws, political power is more decentralized than westerners expect. Thus, even though strong national pressure for courts to enforce the laws may be present, no one knows how local courts will respond.
10. Level of fees to transfer assets. It is unclear whether unpaid taxes follow a property or stick with the individual who sold it. Do unpaid taxes become an obligation of the new buyer? When one buys property, what should bidders assume about these obligations?
11. Laid-off employee liability. Is the new owner subject to a company's liability for employees who have been laid off? In principle, the answer is "yes." When SOEs cease operations, they have obligations to compensate laid-off employees. Whether or not NFL buyers who become the leaseholders of property must assume these obligations is a matter of negotiation between the SOE and the creditor (NFL buyer). If the creditor must assume the obligation, it is unlikely that he/she will want to take over the collateral. In many cases, the price to settle laid-off employee liability claims is determinable in advance and thus becomes a factor in valuing the NFLs.
12. Repatriation of capital. Previously, Chinese law required foreign investors to complete a transaction in order to repatriate capital. NFL investors want to repatriate capital as each loan is resolved in order to boost interim cash flows and IRRs on their invested capital. A November 2002 approval by the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) gives investors the right to repatriate capital (net cash flow after profit tax) as loans are resolved rather than waiting until the entire transaction for a given loan portfolio is completed (Yang, 2002).
13. Favorable tax rates. The government has established Business Development Areas (BDAs, similar to enterprise zones) such as Pudong in Shanghai that offer foreign companies favorable tax rates. If the companies are set up in BDAs, they are entitled to the tax benefits given to the BDA. In addition, companies set up by foreign investors in China to dispose of NPLs are subject to taxes under the current tax structure. However, it is not known yet whether they will be exempted from the business tax that financial institutions now pay. The combination could reduce taxes from 33% to 15%, significantly boosting returns to foreign investors
14. Processing time. Investors price assets based on the time it takes them to get their hands on assets. Buyers of NPLs have yet to go through the process of seizing and getting control of assets. As mentioned above, the processing time depends heavily on the attitudes of local courts. Some cities like Shanghai have more commercially oriented court systems. What will happen in other areas?
15. Land-use rights. The option to convert to another land use provides the NFL servicer a "big stick" to get something out of settlement. (Investors in most cases don't want to get a factory back.) In order for investors to do anything other than the current land use with property they acquire through loan resolution, the property must have a granted land use right. Many SOEs have allocated land use rights which must be converted to granted land use right by payment of a conversion fee to the local authority of approximately 20-40% of the leasehold value (present value of 50-70 year lease). (4) The processing time and actual fee for making this conversion has not been tested and is likely to differ between jurisdictions. The need to pay high conversion fees will leave little loan recovery value to many collateralized properties where the market value of the property with the granted land use right is not much higher than the conversion fee.
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