Blind eye to billions in bad debts
Taiyuan is only a few hundred kilometres south of bustling, modern Beijing, but could be a world away. Decaying grey and brown buildings and yellow-brown wheat fields dominate the Shanxi capital's landscape. From the air, the city resembles a mouthful of rotting teeth.
Because Shanxi produces most of China's coal, Taiyuan is also the mainland's most polluted city. Coal plants belch out giant, cauliflower-shaped soot clouds. The wide grey roads melt seamlessly into the bleak grey sky. Miners in Mao caps and drab, grey clothing bicycle slowly to work and home, seemingly unexcited about reaching either destination.
This is the place Matthew Nelson, a manager at hedge fund DAC Management, left Wall Street for.
The tall, affable Iowa native, an alumnus of Merrill Lynch and JP Morgan, now specialises in buying non-performing loans - debts Chinese firms have racked up but cannot repay. His employer, founded by American former Arthur Andersen accountant Phil Groves, is Hong Kong-based. Still, Nelson spends most of his working days in Taiyuan.
While DAC owns loans attached to failed firms throughout China, Shanxi is a huge source of business. Despite the coal bosses zooming around in 4X4s with blacked out windows, the province has had its fair share of economic woes. It was one of several northern and western regions that became blighted with bad debts in the early 1990s, when scores of state-owned enterprises failed. As unpaid staff rioted en masse, their employers sometimes scored easy cash by halting bank loan payments. In 2003, Shanxi was ravaged by Sars.
Shivering in the sub-zero cold and standing a clear foot taller than most of Taiyuan's inhabitants, Nelson pulls his baseball cap closer over his blond hair as he trudges through the snow in Taiyuan's lacklustre city centre. He is viewing assets owned by DAC's debtors that the fund wants to seize and sell off.
These include a lavish, upscale karaoke bar, frequented by local coal tycoons who must spend at least 1,500 yuan (HK$1,705) a night on alcohol and girls to book a room, the lobby of a four-star hotel, a shopping mall, an apartment block and a car park.
'Let's hang back a bit,' the hedge fund manager says as he approaches the car park. It is clearly not good for him to be seen snooping around.
Nelson is something of an upmarket bailiff. His fund buys its bad debts from China's four asset management companies - China Orient, Cinda, Great Wall and Huarong. The government created these in the late 1990s to hoover soured loans off its biggest banks' books in time for their Hong Kong and Shanghai listings. And even though the state is wealthy, most of DAC's debtors are state-owned enterprises.
DAC owns 254 bad loans in Shanxi, Nelson says. Half of these debts are over 10 years old. The rest are at least six years old. So companies who have got away without repaying loans for years are not happy when the foreign hedge fund turns up on their doorsteps demanding repayment.
DAC owns a Chinese debt servicing business, Gao Fei China, whose mainland staff handle the negotiations with the failed firms. If talking does not work, DAC takes the debtors to court. It aims to seize then sell off their assets.
But mainland judges are rarely sympathetic to its cause.
In Xinzhou, near Taiyuan, the fund owns a 34 million yuan loan that a shopping mall owner took out with a central government-owned bank several years ago and has not repaid.
In late 2007, DAC won a ruling from the Taiyuan Middle Court to freeze the asset. DAC then asked the court to auction the shopping mall off, so they could take the proceeds.
Three years on, says Frank Xu, a vice president at Gao Fei China, that ruling still has not arrived. There are hundreds of people working in the Xinzhou mall, Xu says. He admits he has no idea who is employing them.
'This job is a long, hard slog,' Nelson admits.
Foreign creditors of failed mainland firms threaten social stability. If they are allowed to close or sell bankrupt companies, this threatens jobs.
Bad loans are barely mentioned in the mainland media. But there are masses of them. Because the problem is very old, many non-paying companies have died. So DAC owns some bizarre corporate bric-a-brac, including a yellow Cadillac which was the only asset one of its recalcitrant debtors had left. Nelson drives around Taiyuan in a black Audi acquired from a company who could not repay its loans.
'In the past, we have been paid in ginseng and tennis shoes,' Phil Groves, DAC's managing director, says. 'The ginseng turned out to be pretty valuable. But the tennis shoes were so bad we gave them to charity.'
A decade ago, the non-performing loan problem almost crippled China's four biggest lenders - Agricultural Bank of China, Bank of China, China Construction Bank and ICBC. The central government bailed out the banks in 1998, moving close to US$300 billion worth of their bad loans into the four asset management companies (AMCs). The OECD said in 2005 another US$203 billion was needed to clean up the banks' balance sheets. Eventually the lenders, excepting Agricultural Bank which is yet to list, were bolstered by selling shares in Hong Kong and Shanghai.
The central government does not give exact figures on non-performing loans. The AMCs stopped publishing data on their loan sales in 2006. That same year, Ernst & Young sparked Beijing's ire by suggesting US$911 billion of bad loans were sloshing around the financial system. The accounting firm then retracted the report.
The four asset management companies have a politically sensitive job. They have to sell the bad loans they acquired. But they do not want international firms to make too much profit from restructuring state-owned firms.
They are still selling off debts, says Ted Osborn, PricewaterhouseCoopers' head of business restructuring in Asia and a noted expert on non-performing loans. But to make life easier for themselves, the AMCs mainly sell to mainland provincial governments, Osborn reveals. 'The vast majority are sold to Chinese buyers. Most of those are municipalities seeking to acquire non-performing loans of state-owned enterprises in their jurisdiction.'
The local authorities are keen to relieve struggling taxpayers in their regions from their debt burdens, explains Jack Rodman, Beijing-based president of distressed asset consultancy Global Distressed Solutions.
'The political will, certainly at the local level, is to keep zombie companies alive and local people employed,' Rodman says.
The four AMCs were asked for interviews for this article but all declined.
Sometimes DAC finds that government-owned entities do their utmost to keep bad loans out of its hands.
The fund owns a 120 million yuan bad debt a Shanghai-listed coal firm, Tianlong Group, is responsible for.
Two of Tianlong's shareholders, Donguan City Jinzheng Digital Technology and Taiyuan City state-owned supervision and administration commission are suing DAC, as well as the AMC it purchased the loan from, China Orient, for 15 million yuan.
The shareholders, according to a 2008 subpoena reviewed by the Post, claim China Orient had already agreed to sell Tianlong's debts to them. Donguan and Taiyuan City are government-owned entities. When contacted, Tianlong chief executive Zhang Li Rong said the case had been 'resolved'. DAC disagreed, saying the case was ongoing.
Does it matter that the political will in China is to keep failed companies' unpaid loans in government hands? Shouldn't Beijing compel banks and AMCs to sell them to international investors who will restructure the non-paying companies, perhaps even restoring them to health?
Craig Blomqvist, the head of bad loan advisory specialist Fan Ya Tai asset management, thinks this is unlikely. 'Social stability and full employment are the [government's] objectives and [this] will continue for the foreseeable future,' he says.
Others say that even if there really are over US$900 billion worth of bad loans in the system, the mainland boasts a 33 trillion yuan economy.
As the Asian crisis showed, though, when bad loans pile up, the effect on economies can be toxic. Some economists believe unpaid corporate debts will soar. This could put the brakes on the nation's amazing growth rates.
Northwestern University professor of political science Victor Shih forecast in a January paper that last year's record 9.6 trillion yuan lending spree on the mainland will create over three trillion yuan worth of bad debts.
Writing in the Post last August, Peking University finance professor Michael Pettis said the likely growth of non-performing loans means Beijing will have to bail its banks out again, either by borrowing from abroad, raising domestic taxes or making the banks slash deposit rates. 'Either solution represents a transfer of income from households to banks and will represent a continued drag on consumption growth,' Pettis wrote.
In other words the popular theory that mainland consumers, with their growing incomes, will take up the slack created by sluggish exports to the West needs to be reconsidered.
Beijing needs to deal with the unpaid debts sloshing around different arms of the government more efficiently. Otherwise, investors banking on China's economic miracle continuing should question their faith.
DAC, which already has US$400 million of assets under management, is raising a new, US$500 million fund. Nelson and his colleagues clearly believe the mainland's debt woes could get worse.
Additional reporting by Daniel Ren in Shanghai and Toh Han Shih
Big and bad
Number of bad loans owned by DAC Management in Shanxi: 254