Countdown to 2007

The emergence of China as an economic power has attracted real estate investors of all shapes, sizes and nationalities eager to capitalize on the country's booming property market. At the same time, investors of a different stripe—those in search of distressed assets—have also flocked to China, the world's second largest market for non-performing loans (NPLs).

Fueled by overzealous lending practices, a state-controlled banking industry and poor regulations and controls, the number of NPLs in China has ballooned over the past 15 years. Though determining the exact dollar amount is difficult due to limited financial transparency, a recent UBS report estimated that Chinese banks have created approximately $850 billion in bad loans since 1990, or approximately 40 percent of the net credit issued over that period, according to Standard & Poor's.

China began addressing this issue in 1999, when the government established four asset management corporations (AMCs)—Cinda, Great Wall, Huarong and Orient—to serve as the conduit for state-owned banks (SOBs) to dispose of their NPLs. To date, however, progress has been limited. Many foreign investors who came to China in search of NPL transactions have become disenchanted with the lack of sustainable or predictable deal flow, the relatively small size of dispositions and a perceived preference for domestic buyers.

Nevertheless, in the past two years, China's disposition process has accelerated. The government is pushing ahead with banking reform as it prepares for full integration into the World Trade Organization and the opening of its banking system to foreign competition in 2007 (see “Bank reform” below). For the country's four large SOBs—the Bank of China (BOC), China Construction Bank (CCB), Industrial and Commercial Bank of China (ICBC) and Agricultural Bank of China—these reforms have yielded significant developments. Over the past two years, the government has injected approximately $60 billion of foreign exchange reserves to help recapitalize the three largest institutions and put them on better footing when foreign competition enters the country. In addition, a massive amount of NPLs, approximately $160 billion, has recently been transferred to the four AMCs. And, as the SOBs prepare to go public, international investors such as Goldman Sachs, Temasek and Bank of America have acquired significant minority positions.

Looming over the NPL market is the prospect of another wave of bad loans resulting from the banks' aggressive lending of recent years, particularly in real estate.

Against these notable accomplishments, China's banks continue to face difficult challenges. Questionable lending practices and overexposure to China's superheated real estate sector have contributed to an increase in Category 2, or “special mention,” loans, which suggests that banks could face another wave of NPLs over the next few years.

BANK REFORM
Since 1998, China has enacted measures to more effectively regulate the country's banks, which dominate China's financial system. China has adapted a five-tier, international classification system that ties risk to loan quality and has issued guidelines to tighten controls on mortgage and commercial real estate lending. The China Bank Regulatory Commission (CBRC), headed by Liu Mingkang, a respected former president of the Bank of China, has pressured banks to better control loan and deposit growth, maintain adequate capital, and realize acceptable returns on capital. It has pushed banks to clean up their balance sheets, establish governing boards and improve their due diligence of borrowers' creditworthiness. Banks traditionally have had a strong incentive to pump out loans regardless of the credit risk, among other reasons because their managers' bonuses have depended almost entirely on asset growth. To combat such activity, the CBRC has issued guidelines that hold bank managers more accountable for the disposition of their non-performing loans.

While regulators are to be commended for making progress with bank reform, further reforms are needed. Most of the public's record-high savings are in banks, and banks underwrite the economy, accounting for about 80 percent of all credit allocation in China. Consumers and businesses have few alternatives to banks. China has relatively small stock and bond markets, and only a few financial products and services. Small and medium-sized businesses have difficulty obtaining bank loans, which has helped to fuel an underground loan market. The banks have pumped money into exorbitant infrastructure projects and inefficient state-owned enterprises that were kept going mainly to keep people employed. Their investments have been so unproductive that China has to keep pumping ever more money into its economy to keep on growing. China needs almost $5 of fresh capital to generate $1 of incremental output, a far worse ratio than Western countries and even India.

ASSET MANAGEMENT COMPANIES
China's four AMCs have done well in meeting their recovery targets—two of them, Cinda and China Great Wall, reported hitting their targets a year ahead of schedule, disposing of RMB50.2 billion ($6.2 billion) and RMB53.5 billion ($6.6 billion) respectively, in 2005.

Though foreign investors in the NPL market have often complained that NPL auctions favor domestic buyers, some of the most notable transactions of last year included non-Chinese entities. For example, German financial institution Deutsche Bank teamed up with American insurance giant AIG to form an equity joint venture with Huarong. The equity joint venture houses RMB15 billion-worth of assets from Huarong. Huarong also unloaded RMB1.7 billion of NPLs to Bank of America and Cargill; and the PPF Group, an investment firm from the Czech Republic, walked away with a RMB3 billion portfolio of loans from Orient.

Nevertheless, while AMCs have made strong progress in disposing RMB1.9 trillion of NPLs, they face new challenges going forward. They are under a mandate to complete liquidation of NPL assets and transform themselves into commercial enterprises after 2006. And they may face competition from the banks themselves, which are seeking more powers from the government, including the ability to resolve NPLs on their own. Following the success of CCB's first settled asset portfolio sale, CCB plans to increase its use of auctions to dispose of bad loans; the bank has also announced additional settled asset sales.

The relationships of AMCs and banks that have gone public could also change. If CCB were to require another bailout in the future, this would include an unwanted bailout of foreign investors. As a result, government infusions of capital into CCB and other listed banks, as well as transfers of NPLs from listed banks to AMCs, may be more difficult in the future. With future NPL sales, CCB and other listed banks may need to adhere to a more market-based, commercial pricing and transaction structure that eliminates the AMCs as middlemen, which would be a positive development for NPL investors.

‘HIDDEN’ NPLS
Obtaining accurate information about the NPLs in the loan portfolios of Chinese banks is difficult, among other reasons because of the banks' poor accounting practices, a banking culture that resists openness and accountability, and regulations that limit banks in resolving problem loans that result in a loss of principal. But recent studies by UBS, McKinsey and Ernst & Young illustrate the dimensions of the banks' NPL problems. Back in 1998, the government determined that there were $170 billion in NPLs on banks' balance sheets, which were subsequently transferred to the AMCs in 1999. In 2000, independent estimates identified another $450 billion of legacy NPLs dating back to the early 1990s. Finally, the banks' aggressive lending from 2002 to 2005, including lending in overheated markets like real estate, could result in a new wave of bad loans estimated as much as $225 billion. All told, banks have created an estimated $850 billion in bad loans in the past 15 years, or about 40 percent of the net credit issued over that period.

Obtaining accurate information about the NPLs in the loan portfolios of Chinese banks is difficult, among other reasons because of the banks' poor accounting practices, a banking culture that resists openness and accountability, and regulations that limit banks in resolving problem loans that result in a loss of principal. But recent studies by UBS, McKinsey and Ernst & Young illustrate the dimensions of the banks' NPL problems. Back in 1998, the government determined that there were $170 billion in NPLs on banks' balance sheets, which were subsequently transferred to the AMCs in 1999. In 2000, independent estimates identified another $450 billion of legacy NPLs dating back to the early 1990s. Finally, the banks' aggressive lending from 2002 to 2005, including lending in overheated markets like real estate, could result in a new wave of bad loans estimated as much as $225 billion. All told, banks have created an estimated $850 billion in bad loans in the past 15 years, or about 40 percent of the net credit issued over that period.

Real estate loans are estimated to make up a significant portion of the new wave of bad loans. An earlier Ernst & Young analysis found that hidden real estate loans buried in the “special mention” loan category, which is not included in computing a bank's NPL ratios, implies an additional $65 billion in real estate bad debts based on historical real estate project default rates published by the China Banking Regulatory Commission.

Rather than attempting to solve their NPL problems through asset dispositions and portfolio sales, the banks have merely transferred NPLs to a variety of AMCs. Of the $850 billion, about $330 billion had been transferred to the Big Four AMCs as of the end of 2005. As part of the government's plan to recapitalize and reform the banking sector, two additional AMCs were established to take additional nonperforming assets off the balance sheets of the SOBs: Huida AMC and Jianyin AMC together received NPLs totalling $263 billion.

All told, banks have created an estimated $850 billion in bad loans in the past 15 years, or about 40 percent of the net credit issued over that period.

Almost all of the NPLs generally have been transferred for 50 percent to as much as 100 percent of book value, with the AMCs issuing promissory notes and bonds to the banks. By realizing relatively high values for these assets, the banks were able to reduce their loan losses as they prepared to attract strategic investors and launch their IPOs.

For the AMCs, however, the transfers have not been such a good deal. The AMCs generally have recovered only 21 percent in cash of the value of the NPLs they acquired from the banks, but they issued the bonds at face values that far exceeded the actual recoveries. Now, one of the biggest issues facing strategic investors, banking analysts, rating agencies and accounting firms is how to value the AMC bonds on the banks' balance sheets. The AMCs would be technically insolvent if the bonds were not implicitly guaranteed by the Ministry of Finance. Uncertainty about the Ministry's backing for the bonds and whether the banks could redeem them at face value has complicated the due diligence process for investors and analysts. As far back as 2002, the Bank of International Settlements, the agency responsible for determining international capital adequacy standards, described the government's approach to guaranteeing the bonds as “constructive ambiguity.”

LOANS FOR SALEOverview of China's prominent NPL transactions in 2005