The Next Great China Gold Rush -- Dodgy Debt: William Pesek Jr.
Nov. 24 (Bloomberg) -- It didn't make banner headlines, yet Citigroup Inc.'s investment in a Hong Kong-listed real estate outfit portends one of the big stories of 2005: Chinese debt.
The world's biggest financial services company is grabbing a 16.4 percent stake in Silver Grant International Industries Ltd., an affiliate of China's biggest buyer of distressed assets. The idea is to compete with Goldman Sachs Group Inc. and Morgan Stanley in the second-largest bad-loan market after Japan.
China doesn't have liquid bond markets, yet investors are scrambling to get in on the next Chinese gold rush: More than $450 billion of bad loans held by China's four-biggest commercial banks and their asset management companies. The hope is to buy dodgy loans at a fraction of their face value and sell the assets at a profit as the world's fastest-growing major economy expands.
It's as much an economic opportunity as an investment one. China is growing 9 percent and benefiting from a gold-run mentality that's attracting most of the world's foreign direct investment. Yet its dysfunctional banking system is raising questions about the economic outlook.
China's major banks aren't banks so much as financing arms of the government. That has led to an institutionalized misallocation of capital with little regard for international norms of risk management and the extension of credit. The result is a Japan-like bad loan situation that's limiting the amount of credit flowing to worthy borrowers and economic inefficiencies galore.
$656 Billion in Bad Loans
Standard & Poor's thinks it would cost $656 billion to resolve bad loans at all of China's banks, though some analysts say the figure may be much higher. Repairs are indeed under way, though not as fast as credit-rating companies would like.
In January, China began using tens of billions of dollars of foreign exchange reserves to bail out some lenders. Next it placed greater pressure on bank executives to dispose of bad loans. More recently, it set new rules designed to make it easier for overseas investors to buy bad loans.
This last move is a big step in the right direction and sets the stage for an interesting 2005. The new rules will help banks accelerate the repairing of balance sheets, leaving the economy better equipped to maintain rapid growth.
Overseas investors only have bought bad loans valued at $6 billion in China. Buying Chinese debt isn't for the faint of heart. That was underlined in September by Lone Star Funds' decision to close its Beijing office and reduce activity in China. The reason: a shortage of deals. The pullback by the Dallas-based company is a sign of international investors' frustration at the slow disposal of bad loans and under-performing assets by China's banks.
Transparency Missing
In bureaucratic China, after all, such transactions can take more than a year to complete and require approvals from myriad government departments, including the Ministry of Commerce. The Huarong Asset Management Corp. asset sale in November 2001, the first to foreign investors, still spooks investors. Approvals for the sale took 18 months.
A lack of transparency also means investors aren't always sure what they are bidding on. China's work-in-progress legal system, meanwhile, means the enforcement of creditors' rights remains patchy, at best.
Yet Citigroup's decision to buy a stake in an affiliate of China's biggest distressed-asset buyer is the latest sign the biggest names in banking think it's worth the hassle -- and the risk.
Citigroup agreed to pay HK$845 million ($109 million) for its piece of Silver Grant, a Hong Kong-listed real estate investor controlled by China Cinda Asset Management Co. It also plans to set up a venture with Silver Grant to buy bad loans in China.
Sound Bets?
Only time will tell whether overseas investors are making sound bets on China. Yet there's reason to give them the benefit of the doubt. For example, Chinese banks and asset managers are being pressured to get rid of bad loans sooner rather than later to clear the way for initial public offerings. That may help foreigners buy assets on the cheap.
China may be nearing a phase similar to what Japan experienced in the late 1990s. In the mid-1990s, Japan minimized its non-performing loan crisis. As the 2000s approached, it began to understand just how much of a headwind it was on the overall economy. Investors swooped in, grabbed the low-hanging fruit and are helping accelerate Japan's corporate reform.
If China is at such a stage, it's heartening to see it's opening the market more to international investors. There just aren't enough investors in its domestic non-performing asset market to dispose of dodgy debts as rapidly as the economy needs.
Beyond Bank Loans
The possibilities go far beyond banks' bad loans. China's plans to sell off more state-owned companies like those in the insurance sector are getting the attention of the world's biggest private-equity players. Last month, Carlyle Group, the world's third-largest buyout firm, said it plans to increase investments in China to more than $1 billion from $150 million today.
None of this detracts from what's plaguing China, including risks ranging from economic overheating to poverty to corruption. Yet if you are looking for something that's going right in China, the bad-loan market may be it.
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