The gargantuan scale of non-performing loans (NPLs) in China and regulatory changes are likely to spur an uptick in foreign investment in the world’s biggest distressed asset market. But rising prices have squeezed profits, causing China to lag behind India and Latin America in returns.
James Dilley, a Hong Kong-based associate director of PwC, estimates that foreign investors will close deals for NPL portfolios totalling $1.5 billion to $2 billion in China this year. That is a considerable pick up on the roughly $2 billion invested in loans between 2015 and 2018.
Over the past 18 months, foreign banks and funds have invested $1.5 billion in NPLs in China and $500 million between 2015 and mid-2017, according to a November report from PwC.
Dilley bases his bullish outlook on market conditions. “We know of many funds that are interested in the space and haven't pulled the trigger on their first deal yet. A portion of these will invest this year. Maybe there will be another two to five new entrants,” he said.
The funds he is talking about are typically hedge funds or distressed debt funds which are active in other markets including Europe, and have heard about the opportunities in China.
PwC works with several of the foreign funds that acquired Chinese NPLs last year. The Big Four accounting firm is working on what it calls “two reasonably well progressed” Chinese NPL deals now, which it aims to close before June 30. PwC hopes to close another two to three deals in the second half this year.
“Whether the number is $1.5 billion or $2 billion isn't relevant from a macro perspective. It's lost in the rounding, given the roughly $1.4 trillion stock of Chinese NPLs,” Dilley said.
While the China Banking and Insurance Regulatory Commission (CBIRC) has put the official amount of Chinese NPLs around $400 billion, China-based distressed debt investor Shorevest Partners estimates Chinese NPLs to be as much as $3.1 trillion.
The sheer scale of supply means that there is far less competition on specific portfolio auctions between the international debt funds.
This is different from many European markets, where multiple funds typically compete for a single NPL portfolio being auctioned.
Over the past three years, there have been 27 China NPL deals involving an international buyer, of which only one had two foreign funds competing against each other. Although there can be competition from domestic investors, foreign capital normally deploys larger funds, which means that the threat of domestic competition is less above a $50 million ticket size.
“We expect China's NPL volumes to rise over the next 12 to 24 months. This is largely a result of Beijing's tightening NPL reporting standards,” said Damien Whitehead, a Hong Kong-based partner of international law firm Ashurst.
A new regulation came into force in June last year, that required banks to reclassify all loans overdue for more than 90 days as NPLs.
Before that, Chinese banks could classify some of their troubled loans as “special mention loans” instead of bad loans. Chinese banks are not obliged to report special mention loans, but they are legally required to report bad loans. Some of those characterised as "special mention loans" have not met their repayment obligations for years.
After the new regulation took effect, NPLs in China’s rural banking sector increased by Rmb183 billion ($27.3 billion) in the second half of 2018, according to the CBIRC.
“Driving this regulatory response is the need to deal with rising debt levels in China and perhaps also a recognition of the need to source offshore liquidity to help tackle the problem,” Whitehead said.
Although foreign investors face a large pool of NPLs in China, recent indicators show that the average selling price of NPL portfolios has climbed significantly. It is up from 30 to 40 cents to the dollar in 2016 to between 50 and 70-plus cents to the dollar at the end of last year. No wonder that appetite from some foreign investors has been dampened.
Other challenges that face foreign investors include difficulties in the valuation and servicing of NPLs, enforcement risk particularly in accessing mainland Chinese courts and dealing with local stakeholders.
One executive of a US investor in Chinese distressed debt told FinanceAsia that foreign investors want more realistic pricing in the market. Chinese asset management companies (AMCs) compete to buy NPLs from banks, which drives up prices before they are sold to investors. In China, investors are not allowed to buy NPLs directly from banks but they must buy them from AMCs.
China ranked third behind India and Latin America in the internal rate of return (IRR) on NPLs over the next two years, according to a report by Ashurst and Debtwire released earlier this month.
For China, 69% of the respondents expected an increase in IRR, 26% expected the same and 5% expected a decrease. Investors believe that Latin America offers the best IRR for NPLs over the next two years, with 77% expecting an increase and 23% expecting the same, followed by India with 76% expecting an increase, 22% expecting the same and 2% expecting a decrease.