Pressure on China’s banks to report bad debt is good news for foreign investors
Ted Osborn says China’s banking regulators are making it harder for banks to hide their NPLs. As a result, more bad debt portfolios will be sold to asset management companies and, ultimately, foreign investors
The business of buying and selling non-performing loans (NPLs) in China is supposed to be pretty straightforward. In the late 1990s, when Beijing took active steps to restructure the country’s big four banks, procedures were put in place for them to sell their NPLs to four state-backed asset management companies.
During the first cycle of these loans (2001-2008), things largely worked as Beijing envisaged, resulting in the successful recapitalisation and listing of the country’s largest banks, and the sale of billions of dollars of NPLs to asset management companies and, ultimately, to foreign investors.
China’s second NPL cycle kicked off in 2015 but sales to foreign investors have only recently begun to be ramped up. This is because banks, with mountains of bad loans on their books following rampant lending over the past decade, have been creative in how they deal with their NPLs, leading to fewer sales to the asset management companies than expected.
Banks are often reluctant NPL sellers as sales typically lead to their profits taking a hit. Banks receive continual guidance from Beijing as to how much profit, and thus how many NPLs, they should report. To ensure a smoothly running financial system, regulators prefer to see – and have designed rules that give the banks enough leeway to state – low NPL levels and steady profits. So that’s what banks report.
And that’s why the NPL ratios of the nation’s key banks all hover at about the same level – now around 1.7 per cent of loans. In a recent research piece, Fitch estimates that the real ratio could be as high as 20 per cent, implying total NPLs of 19 trillion yuan (US$3 trillion).
Whatever the level, with reported NPL levels more or less being guided by the regulators, banks struggle when it comes to reporting their bad loans. Report too many and profits would go down to unacceptable levels. Report too few and you are an outlier, inviting scrutiny. This has led to banks taking extreme measures to hide or disguise their NPLs, through such measures as repurchase agreements and sales to related parties at par.
The banking regulator knows what is going on, and in January announced that it had uncovered nearly 60,000 individual cases of bank wrongdoing, including falsifying loan deals and hiding non-performing assets.
But banks are just half of the NPL clean-up problem. In the nearly 20 years since their establishment in 1999, the big four asset management companies have evolved. They now own banks, brokerages, leasing companies and the like, and are less active in the traditional NPL business of their roots. And Huarong and Cinda, both now listed, together with China Orient and Great Wall, have become quite creative when it comes to dealing with their NPLs.
For example, in late 2016, Beijing ordered the big four banks to reduce lending to developers to help cool the property market. It didn’t take long for the asset management companies to devise a win-win arrangement in response: get the developers to buy NPLs from them at par and, in return, give them the low-interest-rate loans they needed.
This enabled the asset management companies to post big profits on their NPL sales and saved the day for the developers, who not only paid less interest on their loans, but also put them in a position to make millions in profits from their property development projects.
Beijing’s recent crackdown on the games that the banks have been playing with their NPLs is great news for the asset management companies and foreign investors. While figures have yet to be released, I expect to see a significant pickup in the volume of portfolios being sold by banks in 2017, and that this trend will continue into 2018 and beyond.
Given Beijing’s focus on the stability of the financial system, the flow of NPLs into the market should pick up considerably in the next two to three years, providing ample opportunity for new investors.
Ted Osborn is a partner at PwC China