A three-shot cure for China’s zombie problem

The country should form new bad debt agencies, encourage foreign distressed debt specialists and create a proper bad debt resolution process, or risk a full-blown credit crisis.

China’s four so-called bad banks have made a lot of money from gorging on bad debts. But they risk having too much of a good thing. 

On March 7, Lai Xiaomin, chairman of China Huarong Asset Management, said in a proposal to the National People’s Congress that the country’s four bad banks, aka asset management companies, were struggling to cope with the latest surge in soured assets. 

Huarong is one of four bad banks set up in 1999 to take on the troubled assets of the country’s four largest lenders – Industrial & Commercial Bank of China, China Construction Bank, Bank of China and Agricultural Bank of China – so as to clean up their balance sheets ahead of planned public listings.

But debts in China have surged further since the global financial crisis of 2008 after Beijing encouraged local governments and state-owned enterprises to spend on investments, supported by cheap bank loans. That pole-vaulted the country’s debt level to an estimated 282% of GDP in 2015, according to McKinsey, with further rises potentially on their way. Lending in January alone reached Rmb2.51 trillion ($385 billion), a monthly record.

The skewed allocation of some of this debt is also becoming increasingly apparent. Sectors such as iron and steel, cement, and shipbuilding, notably, are suffering from severe overcapacity and many of the (predominantly state-owned) producers in them are effectively zombies, unable to pay back the debts they owe.

That has exacerbated the rise in bad debts as China’s economy slows. Chinese banks’ total non-performing loans rose from 1.25% of bank assets at the end of 2014 to 1.67% in 2015, or Rmb1.27 trillion ($196 billion), according to the China Banking Regulatory Commission.

Some investment bank analysts believe the rate is probably far higher. Chinese banks are often unable to pressurise state-owned enterprises to repay their debts or are loathe to declare them insolvent because these companies are well-connected to local or national politicians. So instead they are forced to keep rolling the loans over while bad loans mount in the system.

That could lead to even bigger bad loan problems, more than the four AMCs can handle.

Hedge fund manager Kyle Bass argued in February that China’s banks typically lose over 10% of assets in an NPL cycle. Based on where the market is today, that would mean lenders losing at least $3.5 trillion in equity -- a scary, indigestible figure by any measure. 

At the same time, Beijing has stated that it intends to maintain the country's annual GDP growth rate at 6.5% or more over the coming year years. To support this, the banks need to lend to healthy companies. That means getting more of their assets out of the zombies.

Time for new bad banks

Three steps could help free some of these assets up. First, Beijing could create new national bad banks; second, it could encourage greater involvement from international private distressed debt companies; and third, it should create a transparent, meaningful debt resolution process.

The four existing AMCs simply lack the capacity to handle the level of bad debts found in the nation. So Beijing either needs to directly bail these banks out, in effect recognising the extent of the dud loans pervading its economy, or it needs to shift them to other institutions.

The latter might prove the more politically palatable. By creating – and capitalising – new AMCs, the Chinese government, in effect, will still be using its own capital to solve the problem. But it does so one step away from doing so directly.

Additionally, these bad banks will be able to raise capital themselves, by issuing bonds for example, to help fund their own needs. And they would be able to focus solely on renegotiating the bad loans, without having to worry about whether doing so will upset companies that are customers across multiple product lines.

The new AMCs would also help to address the sheer size of the country’s likely bad debts today as the four existing bad banks are far too small to handle such huge sums. 

Encourage foreign investors

Another way to help diversify the growing debt risks in the financial sector would be to allow in more international bad debt companies, and to support them in subsequent negotiations over bad loans.

There have already been a few instances of foreign asset managers targeting China assets but it has not been simple. Oaktree Capital formed a distressed debt joint venture with China Cinda in November 2013 but after two years admitted that it was proving tough to buy assets cheaply. Meanwhile global private equity company KKR teamed up with China Orient to target distressed real estate assets.

The key complaint of one foreign investor who works in China is that the country's courts are slow-moving and seem better-disposed towards zombie companies than their creditors. 

"China should streamline the workout process so it doesn't take so long for the courts to make a decision. At the moment we are snowed with bureaucracy," he said. "The judges are so conservative, they don't want disputes over collateral. Above all they don't want to provoke demonstrations and social unrest. If the borrower asks for more time they usually get it."

He notes SOEs in particular tend to get special treatment, while the courts tend to be less favourable to foreign distressed debt holders. "Maybe it's easier to say no to us."

Introduce a rigorous resolution process

China's central and regional governments also need to introduce a clear bad debt negotiation process if they are to encourage foreign and local companies to buy bad debts.

This should take into account explicit creditor seniority - another area of investor frustration often fudged in the legal process - and concrete timelines for restructuring discussions. Insolvency should be a real possibility in the event a solution cannot be reached. 

The process would require explicit political and support to work, which might seem unlikely. But Beijing could essentially use these firms to push forward the SOE reforms that President Xi Jinping’s government said are integral to reduce losses and improve efficiency in the country.

It would do so by fully empowering these distressed debt companies to conduct necessary debt resolutions with smaller, non-essental SOEs. This would offer the authorities a key benefit too - workers opposed to restructurings, lay-offs or asset sales would likely focus their anger on their distressed debt creditors, not Party officials. 

It's never a pleasant task to battle zombie companies but the need to do so in China is mounting. Better the government address it now, rather than wait and risk seeing this horde of corporate undead infect the entire economy. 

Additional reporting by Alison Tudor-Ackroyd

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