Zhu Kuan debacle heats up

Foreign bankers determined not to give up on the defaulting Zhuhai city government.

Oscar Wilde once said that losing one parent was a tragedy, while losing two was careless. Initially, observers can't help but share similar feelings over the latest debacle involving a raft of foreign banks lending to the mainland, in this case, just under $1 billion in loans to the window company of the Zhuhai city government, Zhu Kuan.

The creditors are Standard Chartered, Bank of America and Bank of China (HK). The latter is the single biggest creditor, although with a less than 50% share.

The case is, of course, reminiscent of the Guangdong international trade and investment company (GITIC) which was officially declared bankrupt in January 1999 owing just over $5.6 billion and having assets of half that. Foreign investors were scandalized that the bonds were not guaranteed by the central government and that foreign debtors would have to take their place in the line with domestic creditors and the workers who lost their jobs due to the bankruptcy.

The Zhu Kuan scandal, which has been rumbling on since 2001, has also highlighted the weakness of foreign bankers when the going gets tough.

Creditors usually can't afford to be too openly angry at the slow legal pace on the mainland, since with the enforcement of decisions almost always weak, and the content of the decision dependent on powerful local relationships, staying on the good side of the Chinese party is one of the only ways of obtaining at least a partial redress.

The fact that the debt was in the form of bank loans, not bonds, made this procrastination and softly-softly approach much easier than with GITIC. The latter's debt was in bond form. Bond repayment schedules are much stricter affairs than bank loans.

However, it looks as if the Western bankers have changed tack.

"For a long time a lot of Western creditors were taking the mayor and other officials out for lunch, but eventually people realized that it simply wasn't working," says one executive who has worked on the deal.

One specialist says that local courts can be relatively efficient with domestic debt, but remarkably tardy with foreign debt. It's possible that this is a reflection of a reluctance by local government to push local workers out of their jobs through foreclosure for the benefit of foreign bankers.

It looks as if neither the Zhuhai officials, nor the foreign banks, will come out looking especially good. The foreign creditors' cries for compensation highlights the privileged position of such institutions, which author and columnist Martin Wolf has described as making profits privately and losses public.

Specialists in Hong Kong, however, deny that the GITIC case is similar to the Zhu Kuan case.

Indeed, there is a distinct air of fury amongst the professionals working on the case. One typical comment was that while evasive manoeuvres were common amongst the seedier type of private citizen, it was unprecedented to come across such devious behaviour from a local government.

As in the GITIC case, it is tempting to ponder why foreign creditors were making such loans to a company which ended up so badly, but sources say that the loans were not in the least bit suspect.

"Bankers were making loans based on written guarantees by the city government and on collateral. The assets used to shore up Zhu Kuan's balance sheet and to use as collateral by the banks for loans were pumped into the company by the city government specifically for this purpose," says one source.

Zhu Kuan's problems arose when its large property portfolio ran into difficulty in the aftermath of the Asian financial crisis.

While the foreign banks were confidently expecting to either cover their losses through the collateral they had been provided with, or through a bailout under the terms of the city government's loan guarantee to Zhu Kuan, the city government had other plans.

It started to strip out the assets from Zhu Kuan and hand them over back to the city government - leaving nothing for the foreign creditors.

That's despite the fact that the city government was the prime beneficiary of Zhu Kuan's activity, to the tune of over half a billion dollars from the total of $1 billion in funds provided by the window company. The city government has captured another $200 million in taking back the assets.

What has made the banks furious is that they feel that ever since the city government agreed to restructure in 2001, negotiations regarding the resturcturing have simply been a cover and that the government always intended to shift the company's assets back to itself.

"An appalling display of bad faith," says one source close to the deal, pointing out that a deal had been reached in 2002, under which the foreign banks would recover $0.40 to $0.60 on the dollar - only for the agreement to be ripped up with no explanation a short time later.

He adds that the executive vice mayor of Zhuhai had visited the creditors on the very day following the first asset stripping operation without mentioning the action to the group.

Cos Borrelli at RSM Nelson Wheeler Corporate Asia Group adds that the city's government and its various departments have systematically prevented the Hong Kong appointed provisional liquidators from doing their jobs by using legal blocking strategies.

"When we wanted to get titles from the land office concerning the land that had been collateralized, we were met with a series of ridiculous excuses, such as that the computer was broken or that there had been a power outage. In the end, we were escorted from the premises."

Worst of all is perhaps the disappearance of the company's records. "All relevant accounting documents and books and records have been removed from the company's premises in Hong Kong and Macau and taken to Zhuhai. However, the government has refused the provisional liquidators access to them," says Borrelli.

The company's assets are spread over Hong Kong, Macau and Zhuhai. Although proceedings in the first two jurisdictions have gone smoothly, despite the illegal removal of the relevant documents in Macao, the bulk of the assets lie in Zhuhai.

According to Borrelli, there is zero likelihood the foreign banks will walk away from this one.

"We have never seen such behaviour from ordinary citizens let alone a government. However much time and money it takes, the provisional liquidators will not give up until either the creditors receive suitable compensation from the government or the assets of the group are returned and those responsible are brought to account," he says. In addition, the liquidators have launched court proceedings in Hong Kong, Zhuhai, Macau and the British Virgin Islands.

One source says that given the anger on the foreign creditors' side, he believes it is likely that criminal charges against members of the Zhuhai city government could be next in line.

Indeed, one suspicion is that the government's confiscation of the accounting documentation is that they could divulge that many of the missing assets did not go on public infrastructure projects but were diverted for personal use by Zhuhai officials.

There's a bigger angle to this debacle.

On the Chinese side, the threat of the foreign banks shows the Achilles heel of the Chinese financial system. The mainland government has done an effective job of cutting its finance sector off from the outside world through a pegged currency, a closed capital account, and heavily regulated forex borrowing. That quarantine ensures that bouts of financial influenza, such as the currency crises of the late 1990s, don't hit China. The downside of that cozy insulation is that all sorts of appalling shenanigans never come to light. Similar to the emperor with no clothes, as long as all parties shuffle money around and trust the system works, panic is kept at bay.

But when foreign banks start knocking at the door and threaten to disobey the rules, they also threaten to topple the house of cards. As they did with GITIC, they can close down loans to other itics and put serious pressure on the whole structure.

In theory, China's external debt situation is comfortable, making any default by Zhu Kuan unlikely to have a macro impact. At the end of 2003 China had foreign-exchange reserves of about $403 billion, but estimated external debt of just $182 billion (13% of GDP).

As an additional safeguard, local and foreign companies have to go through the State Administration of Foreign Exchange (SAFE) when they apply for foreign debt. The former need SAFE approval, while the latter merely need to keep SAFE informed since their borrowing is not subject to SAFE approval.

But getting their hands on foreign currency, even if illegally, is a must for many executives and officials, and during the Asian financial crisis it emerged that many companies had far greater forex debts than were officially on the books. Illegal practices also came to light in the GITIC case and culminated in the jailing of the president Huang Yantian for fraudulently obtaining deposits.

The upshot of the GITIC case was that the initially tough stance of the central government was softened after foreign lenders slammed the brakes on lending to the other 200 trust and investment companies - causing some of the weaker ones to fold.

When proceedings were finally wound up in February 2003, the average payback was a scant 12.5 cents on the dollar, or $306 million.

At this stage of the proceedings it's impossible to guess what the Zhu Kuan payback will be. Given the atmosphere in Hong Kong, it seems as if the hot war has only just begun.

What's for sure, is that more and more foreign creditors will be asking about the role of the central government when the accusations against its provincial subsidiary are so serious.

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