China's toxic debt doctors prepare for surgery

Wu Hongyuran and Huo Kan

Regulators eager to resolve China's local government debt conundrum are setting standards for an emerging class of asset management companies (AMCs) responsible for settling bad loans without Beijing's help.

One standard, issued in early-December by the China Banking Regulatory Commission (CBRC), set the floor for each local AMC's registered capital at 1 billion yuan. It was the first financial parameter of its kind since CBRC and the Ministry of Finance started promoting these debt restructuring vehicles in May 2012.

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Also in December, CBRC spelled out management staff requirements and corporate governance rules for AMCs.

Every province, autonomous region and municipality in the country is being encouraged to form a single AMC to take over and restructure non-performing assets held by local banks and local government financing vehicles.

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Last year, Jiangsu and Zhejiang provinces, both in the east, became the first to heed the call. The Guangdong and Shanghai governments are close to launching AMCs of their own.

And Caixin has learned that an unnamed provincial government in central China is likewise gearing up with 1 billion yuan in registered capital from the province's largest state-owned investment group.

Beijing authorities could be expecting each of the 22 provinces, five autonomous regions and four municipalities to form an AMC without central government prodding, said a CBRC branch director in a central province where, so far, local officials have not submitted a plan.

Once in place, a local AMC is expected to complement existing debt-cleanup operations carried out by the central government's four AMCs – China Oriental Asset Management, Cinda Asset Management, Huarong Asset Management and Greatwall Asset Management.

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National AMCs have been processing bad assets inherited from the biggest, state-owned banks since 1999. And their power runs deep: They have permission to arrange asset liquidations, debt-equity swaps and bankruptcy auctions.

Local AMCs, whose tasks are limited to debt incurred within the local government's boundaries, would have less clout and fewer responsibilities.

"Establishing a provincial-level AMC can achieve two benefits by maintaining the value of state-owned assets and promoting development at companies" burdened by toxic assets, said a source close to the provincial investment group that is putting together an AMC.

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Mounting Debt

Exactly how much debt might fall into local AMC laps is subject to debate. The central government's National Audit Office said direct liabilities held by all local governments totaled 10.9 trillion yuan as of July 1. About 45 percent of that amount was supposed to come due before the end of this year, although it's likely much of this debt could be rolled over.

State-owned banks have shouldered the bulk of this bad debt. According to the CBRC, non-performing loans on the books and ratios of non-performing-to-total outstanding loans rose slightly in the third quarter 2013 from the second quarter. Other sources, however, call these recent increases substantial.

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As of October 1, CBRC said, banks were saddled with 563 billion yuan in bad debts, up 24 billion yuan from the end of the second quarter. The country's Big Five banks – Industrial and Commercial Bank of China, China Construction Bank, Bank of Communications, Agricultural Bank of China and Bank of China – finished the third quarter with a combined toxic debt balance of 336.5 billion yuan, the banking regulator said.

The entire banking industry's ratio of non-performing loans to total outstanding loans was 0.97 percent as of October 1, up 0.01 percentage points from the previous quarter, CBRC said. The ratio for the Big Five was 0.98 percent.

A bank industry source who declined to be named said CBRC's decision to announce a new set of standards for local AMCs in December may have come in response to an increase in bad debts during the fourth quarter.

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Indeed, according to a survey released December 24, many industry insiders believe the bad-debt ratio may be significantly higher than what Beijing authorities have been willing to reveal. A survey of 1,604 executives at 76 banks conducted jointly by the China Banking Association and the auditing firm PricewaterhouseCoopers found a whopping 40 percent of respondents estimated the nationwide, all-bank non-performing loan ratio rose in 2013 from 2012 to between 3 percent and 5 percent.

Most bankers responding to the survey think the biggest jumps in bad debt came from loans to metallurgical sector companies such as steel mills, shipbuilders and real estate developers.

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Separately, an Orient Asset Management report said bad loans held by commercial banks may have jumped 5 percent in 2013 from 2012. The report also suggested banks have yet to document the depth of the problem because "true credit risks have not been fully reflected" by balance sheets.

Ni Jun, an analyst at Greenwoods Asset Management in Shanghai, called non-performing loans "a nationwide problem."

And some CBRC officials at local levels have signaled concerns that contradict the rosy picture painted by the commission's nationwide bank data. For example, in December the commission's branch in Shanghai warned banks about rising risks tied to real estate loans.

"If housing prices fall," said one CBRC official, "this year's new loans will become next year's bad assets. Banks need to pay attention to real estate risks."

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Local Focus

The emerging AMCs may be also tasked with cleaning up local government debt that has accumulated in recent years through provincial, city and county financing platforms, several sources say. These platforms, unique to China, borrowed heavily to finance public projects such as new roads and government buildings after the 2008 financial crisis.

So far, the sources said, neither the Jiangsu AMC nor its Zhejiang counterpart has tried to tackle platform debt, primarily because they lack adequate capital for such huge assignments.

Nevertheless, the platform debt problem may not be as serious as some financial industry experts have feared. So far in Zhejiang, said a source close to the provincial AMC, none of the region's debt tied to government platforms had faced a serious default risk.

Working in the platforms' favor is high liquidity in industrially strong Zhejiang and Jiangsu, said the source, which helps keep this debt under control.

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A CBRC official who oversees banking in the Yangtze River Delta region, which includes Jiangsu, said local government financing platforms are keeping up with loan interest payments.

But Jiangsu's AMC, according to a source close to that entity, is mainly handling only unpaid loans tied to troubled steel manufacturers and steel traders. It has not touched the toxic debt held by the province's banks stemming from troubled solar power equipment manufacturers and shipyards.

The source said the Jiangsu AMC, with 5 billion yuan in registered capital, has the power to dispose of up to 2 billion yuan worth of non-performing assets. But the local debt pit may be considerably deeper – perhaps too deep for the AMC, he said.

In the first half of 2013, said a source close to CBRC's Jiangsu branch, about 42 percent of the 21.3 billion yuan in outstanding loans to steel manufacturers and traders had been marked as non-performing.

Yet Jiangsu's AMC is probably much stronger than comparable entities expected to emerge in other parts of the country. Experts say most provinces are likely to form AMCs that only meet the minimum registered capital requirement of 1 billion yuan.

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Market Goals

When central government regulators initially decided to promote local AMCs, many predicted the emergence of a market-oriented solution to toxic debt. But government restrictions on debt disposal and a lack of financial transparency have cooled expectations of private investor involvement.

Some critics say these new AMCs may become no more than parking lots for bad loans assumed from banks. Yet that may fit the banks' business plans, giving them an incentive to cover AMC liabilities with new loans.

It's true that CBRC has been encouraging private investment in local government AMCs, said a source close to the Zhejiang AMC, but to date "there has not been much of need for strategic investors because banks have lined up to offer AMCs credit at low interest rates."

Moreover, central government regulations that restrict toxic asset disposal methods may lead banks and local AMCs into a revolving door. For example, the rules say an AMC must dispose of toxic assets by restructuring them. They cannot hold bankruptcy auctions or sell bad debt.

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As a result, AMCs may wind up borrowing from banks to service bad debts that the rules say they must hold until conditions are ripe for restructuring.

A source close to the Zhejiang AMC said asset disposal rules are so restrictive that AMCs are not even allowed to swap bad assets among themselves.

Bankers said that in general a debt restructuring through an AMC would be a last resort means of handling a non-performing loan. But a bank might cut a deal with an AMC that sees potential value in property or other collateral used for the loan that turned toxic.

A source at China Construction Bank's branch in the Jiangsu city of Wuxi said the provincial AMC has been known to negotiate deals with steel companies in arrears because their land and factory buildings are considered valuable. The AMC can lease factories to other companies and hold property based on a bet that its value would appreciate.

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Jiangsu's success stories have been clouded, however, by transparency issues. Some have accused existing AMCs and banks of collaborating to violate Beijing's regulations.

Reportedly, some banks have shifted non-performing loans to AMCs temporarily for accounting reasons. Later, the banks have taken back the debt and paid handling fees to the AMCs.

The chance to make money by simply holding bad debt for a short period of time, coupled with the central government's push for toxic debt resolution, are among reasons why some analysts expect steady growth in the ranks of local AMCs.

One optimist is Greenwoods' Ni. "It will not be long before many more local governments rush in and set up their own AMCs to take over the banks' bad loans," he said.