Mainland alchemists turn damaged zinc into solid gold
The case of Huludao Nonferrous Metals shows how some financial wizardry can keep a company afloat without changing its base state
China has been telling the world not to worry about the bad debt of its banks. Central bankers reassure us the situation is manageable.
Sceptical foreign investors can, perhaps, take some comfort from the wisdom and calmness of their mainland counterparts. The 3.5 billion yuan (HK$4.3 billion) loan default announced by the Metallurgical Corporation of China (MCC) is most telling.
Its subsidiary defaulted on a one billion yuan loan and had guaranteed 90 per cent of a 2.5 billion yuan overdue loan of an associate, Huludao Zinc Industry (HZI).
The bad news revealed in September pushed MCC's price down by 11.5 per cent. Ironically, Shenzhen-listed HZI rose 6.78 per cent in the same period, outperforming the Shenzhen index. HZI trades at 2.54 yuan while MCC is only HK$1.46.
Mainland investors aren't stupid; their optimism is bred from experience. They have seen how such problems are "managed" on the mainland.
HZI was born in financial distress. With obsolete equipment and a grandiose headcount, the state-owned nonferrous metal industry in Huludao, Liaoning, has always been a money pit for the government. To pay the bills, local authorities managed to list its zinc factory as HZI in 1998 by stripping it of all debt, which was passed on to four loan managers set up by Beijing. In 2002, the debt became stakes in the newly established Huludao Nonferrous Metals Group (HNMG), whose only profitable asset is its controlling interest in HZI.
"HNMG has poor earning capacity. For the sake of social stability, it has to shoulder massive social responsibilities, resulting in heavy expenses," HZI's independent financial adviser said in its report. HNMG lost more than 700 million yuan between 2003 and 2005.
Despite that, state banks did not hesitate to lend to HNMG. By 2005, it had 4.5 billion yuan in debt and a debt-to-equity ratio of 918 per cent. More money had to come from somewhere.
HNMG had drained away more than 1 billion yuan from HZI by early 2006, according to the report. That was far from enough. Late that year, HNMG's debtors sold down its stake in HZI from 58 per cent to 38 per cent. In the meantime, HZI's profit was going south.
In a market economy, both would have gone bust. Not in China. In 2007, MCC acquired HNMG and therefore HZI. Given MCC's status as a central state-owned enterprise, the duo were back on life support.
Everybody was happy. But the fresh supply of money did little to change the fundamentals. HZI amassed 1.6 billion yuan in losses in 2007 and 2008. It would have been delisted if it reported a loss for the third year in 2009.
Magic was performed again. In 2009, the combined company was listed in Hong Kong as part of MCC. How was it possible? MCC's great size easily absorbed them without them being noticed. That's both in terms of numbers and information disclosure. (In fact, 99 per cent of the figures you read here come from HZI reports.)
To be fair, the prospectus did say this segment lost 17 million yuan in 2008 due to the loss-making Huludao business and profit of 436 million yuan in the first half of 2009 came from a smaller loss of the Huludao business. No one was going to shout at these figures when MCC's profit is 3.2 billion yuan.
The final touch came in the last week of 2009. The Ministry of Finance gave various tax rebates to HZI, pushing its bottom line to 90 million yuan overnight. Gone were the delisting threat and the potential embarrassment to MCC.
With the new backing, HZI's bank borrowings rose from 3.12 billion yuan to 4.2 billion in September. Dying HNMG was renamed MCC Huludao Nonferrous Metals and re-emerged as a trustworthy guarantor. Its guarantee for HZI rose from 1.8 billion yuan to three billion yuan during the same period.
More than 10 banks - including the four big state-owned banks; five provincial or city banks and even HSBC - lent money to HZI, even though HZI and HNMG were in the red in 2010 and 2011; HNMG's copper output has been halted; MCC has written 2.2 billion yuan off its investment in HNMG, leaving only the market value of HZI; and HZI's loan-to-equity ratio was 4,029 per cent in 2011.
"Everybody's lending because of the MCC name, or should I say the state," a mainland banker said.
Don't call the bankers reckless. After all, you've already read how the state has delayed writing off bad debt for more than a decade in Huludao's case.
What will the optimism of the bankers and mainland investors yield? It won't take long to know - if the authorities do nothing to push HZI back into profit by New Year's Eve, it will be delisted under mainland rules. Let's see.