China's resolution of its bad loan problem through AMCs is a Great Leap Forward

The non-performing loans of Chinese banks has been nagging at the back of investors'' minds for months. But the establishment of the asset management companies brings in asset recovery professionals for the first time in China''s recent history.

In many ways the AMCs represent a profound generation shift in the attitude of the authorities to the problems of NPLs, estimated at $500 billion or 50% of GDP, and the results so far are encouraging.

Huarong AMC, twinned with the Industrial and Commercial Bank of China recently announced it had achieved a cash recovery rate of 32.5% last year after disposing of bad assets with a book value of RMB 23.21 billion ($2.83 billion).

Great Wall, twinned with the worst performing bank, the Agricultural Bank of China, achieved a cash recovery rate of 24% from a nationwide auction of RMB 4.8 billion in December. Cinda, twinned with China Construction Bank, announced a cash recovery rate of 35.1%.

These represent major steps in tackling China's potentially crippling NPL levels.

Accurate levels are hard to come by, although Bank of China announced a figure of around 29% in December 2000, down from 39% the previous year, thanks to sales to its AMC. The other three big banks are believed to have similar levels.

The banks, unlike the relatively impressive efforts of the AMCs, were passive in forcing debt collection from their borrowers, preferring to simply roll over the loans, the bulk of which were one-year working capital loans, regardless of the financial state of the borrower.

Indebted companies were often supported by the legal system, which in the name of social stability, often persuaded the banks not to exert due pressure on businesses.

Banks were also hamstrung in their efforts to collect debt by provisions in the Banking Law preventing banks from negotiating discounts on the loans.

However, the arrival of the AMCs, and the bold, but so far unique, declaration by BOC of its NPL levels, signal a sea-change in the attitude to NPLs.

The other banks are cautiously following BOC's example of using a five-category classification system instead of the old system, under which banks merely indicated how many days overdue loans were.

Much optimism has been generated by the recent sale of Huarong, the AMC twinned to ICBC, of RMB 10.8 billion loans to a consortium composed of Lehman Brothers, Salomon Smith Barney and led by Morgan Stanley. RMB two billion were also sold to Goldman Sachs in December.

Under the terms of the deal with Morgan Stanley deal, Huarong gets the benefit of a lump sum up front while sharing in the remaining proceeds through a joint venture set up with Morgan Stanley. The International Finance Corporation will either lend funds directly to the joint venture or act as a guarantor of the loan from a local bank.

Under the terms of the deal, international investors may remit the bulk of their profits outside the country, while a portion must be kept as registered capital in the joint venture. This portion may then be remitted out of the country once the joint venture is wound up.

A possible blip on the horizon is that while these conditions are apparently legal under existing Chinese law, the country's central bank, the PBOC and the ministry of finance will give the deal a final review, although their formal approval is not apparently necessary.

"We are operating under the tacit understanding that the deal will go through without a hitch - we do not expect any surprises," comments Jack Rodman, Managing Director, Asia Pacific Financial Solutions, of Ernst & Young, which was closely involved in the deal.

On the plus side, the presence of international investors on the scene is in stark contrast to the behaviour of Korean banks for example, which kept their heads stuck firmly in the sand until the Asian Financial Crisis in 1997.

Even after they were forced to get to grips with their NPL problem, early attempts to sell loans to foreign investors were met with a nationalistic hullabaloo.

"It's extremely encouraging that foreign investors are participating in the resolution of the NPL problem at this relatively early stage," comments Terry Chan, banking analyst at Standard & Poor's.

However, Chan is sceptical about Huarong being able to continue such a high rate of recovery.

"What Huarong has been picking off is the 'low hanging fruit' or the plum assets, but we estimate that on average the recovery rate will be on average $0.20 on the dollar. That means that many of the succeeding batches of loans will have recovery rates of zero," he warns.

The big risk for Chinese banks is whether or not they will be able to retain the trust of their domestic depositor who are ensuring that while technically insolvent, the banks are bursting with deposit liquidity.

But in light of the habits of many decades most analysts believe this is unlikely, at least in the absence of any economic or political shock.

The arrival of foreign banks competing for retail deposits by 2005 could put pressure on the banking system, although analysts say that most the focus of the new arrivals will be on the coastal cities and the growing middle class, rather than the many millions of workers and peasants who have their life savings in the state banks.

Paradoxically, as long as the threat of any major shock to the system is absent, it could be beneficial for the NPL problem to be drawn out over a lengthy period of time. This would prevent the collapse of asset prices through a precipitous dumping of NPL assets onto the market.

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