China conjures up new ‘bad bank’ magic trick; Solution to prospect of growing bad debts is same as in the past

October 24, 2013 6:04 am

China conjures up new ‘bad bank’ magic trick

By Henny Sender

Solution to prospect of growing bad debts is same as in the past

Beijing is authorising the establishment of a second batch of so-called bad banks, this time at the provincial level, as it continues its slow move towards more financial deregulation. This time around the incentive is to prepare for any nasty side-effects as interest rate controls are gradually relaxed. Those include a rise in the cost of capital for already cash-strapped Chinese companies as well as the possible risk of accidents in Chinese banks that have not had to worry about asset liability management in the past. The purpose is also to deal with a new round of bad debts following the stimulus programme adopted in the wake of the global financial crisis.That programme, with a price tag of between Rmb1.1tn and Rmb4tn depending on the calculation used, contributed to overcapacity in sectors including cement and steel, infrastructure projects whose viability is questionable, and sprawling apartment blocks in towns that may one day need them but not today.

The solution to the prospect of growing bad debts is the same as in the past. That is to say, socialise the debt through the creation of a new generation of asset management companies, which will take the banks’ problem loans at a price that is not transparent using money whose ultimate source is not clear.

The usual method does not involve actual cash transfers but rather the transfer of assets from the balance sheet of one state-owned entity to another. But it remains to be seen how long China can engage in such transfers and other financial sleight of hand.

Cavalier debt treatment

Debt in China has generally been treated in a cavalier fashion by both borrowers and the government. But as China’s financial markets become increasingly integrated with the rest of the world, and capital controls are slowly dismantled and the renminbi becomes a contender for status as a reserve currency, as per Beijing’s desire, that attitude will have to change.

While lending in China is no longer political, the resolution of bad debts has always been highly political. The hope is that the resolution of the latest round of problem loans might be put on a more commercial basis.

The first asset management company is being set up in Jiangsu province near Shanghai on the eastern seaboard of China. Jiangsu has been especially hard hit because many companies in two of the most troubled sectors, shipbuilding and solar, are located there. For example, the local branches of several of the largest Chinese state-owned lenders declared Jiangsu-based Suntech, at one time the largest solar company in China, in default a few months ago. Creditors hope the new asset management firm will provide financial assistance to preserve jobs where its principal factory is located, in Wuxi in Jiangsu.

Authorising bad banks at a provincial level is also part of a continuing adjustment in the financial relationship between Beijing and local governments. The central government has long sought to reduce the influence of local governments on the local branches of the big banks. “But now Beijing understands that when there are problem debts, they need the local governments to enforce decisions of the local courts,” says the head of one local investment firm with close relations in China.

Extend and pretend

The last round of bad banks or asset management companies was created to get the bad loans off the balance sheets of the four state-owned banks as they prepared to go public a decade ago. They were financed by bonds from the ministry of finance that they may or may not have paid back fully, in the Chinese version of amend, extend and pretend.

These institutions, established to work out the bad debts and then be wound down, have instead matured into well-rounded financial firms with a life of their own. Cinda, the bad-bank arm of China Construction Bank, is preparing to go public, most likely in November, while the Huarong arm of ICBC will list next year.

Foreign investors in entities such as Cinda say this first generation of asset management companies has little interest in playing the bad loan game any more. The process is too political and too difficult.

Meanwhile, foreign investment firms are gearing up to bid for such portfolios. They believe property lending is far less perilous than lending to sectors with overcapacity (cement, steel, solar, shipping) or industries that have yet to undergo sharp consolidation. (Does China really need 169 carmakers?) But it remains to be seen whether it will be the connected or the deserving that will be given a helping financial hand.

The struggle should prove entertaining, but may be better watched from a safe distance.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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