Making money from non-performance

There are considerable opportunities in the Chinese non-performing loan (NPL) market, but foreign involvement has so far been scant. Albert McLelland and Sunny Lin cast an eye over recent developments.

Before reviewing China’s NPL market, and perhaps to better understand the current situation, it is worth briefly reviewing the historical role of China’s “big four” commercial banks.  Namely:

Bank of China;
Agricultural Bank of China;
Industrial and Commercial Bank of China; and,
China Construction Bank.

The big four were established as a result of the restructuring of the People’s Bank of China (PBOC) in the 1980s and have dominated the deposit and lending market in the People’s Republic of China (PRC) since their inception. Like the PBOC, the big four were not run as “commercial” banks in the Western sense but, instead, as catalysts for political and social agendas. Consequently, it is hardly surprising that the big four amassed significant NPLs, since lending was often directed by the state to support industries and individual localities with little regard for loan repayment.

In fact, as a result of lending to state-owned enterprises (SOEs) and other state initiatives, it was estimated by Standard & Poor’s that over half of the banking system’s loans were non-performing by international standards. This translated into roughly $680 billion or roughly 60 percent of GDP. 

Asset management company (AMC) formation

It should be noted that the state’s estimates of NPLs were significantly lower but, at the same time, the government also recognized the threat to continued growth, in general, and the banking system, in particular. Consequently, in 1999, the state adopted a variation of the classic good bank/bad bank model and set up four asset management companies:

Bank: Bank of China
Asset management company: China Orient Asset Management Corporation (“China Orient”)

Bank: Agricultural Bank of China
AMC: China Great Wall Asset Management Corporation (“Great Wall”)

Bank: Industrial and Commercial Bank of China
AMC: China Huarong Asset Management Corporation (“Huarong”)

Bank: China Construction Bank
AMC : China Cinda Asset Management Corporation (“Cinda”)

The government provided the AMCs with paid-in capital of roughly RMB40 billion ($4.4 billion) and the first stage of NPL acquisitions lasted until the middle of 2000. During this period the four AMCs acquired approximately RMB13.9 trillion ($170 billion) in non-performing loans that mainly consisted of loans that pre-dated 1995 and were, at least, one year overdue as of 1998. The difference between the paid-in capital and the acquisition costs was funded by allowing the AMCs to issue bonds to the banks.  The bonds were backed by a guarantee from the PBOC, which accomplished the goal of cleaning up the balance sheets of the big four and effectively transferring the risk to the PBOC. According to government statistics, by the end of 2004 the AMCs had resolved about 48 percent of their NPLs bought in 2000. According to official government sources, the cash recovery rate on these has remained around 20 percent, cumulatively.

Additional sales driven by big four listing

In 2004, China Construction Bank and the Bank of China announced plans to go public before the end of 2006. This resulted in a further purchase of another RMB279 billion ($34 billion) in NPLs from this bank by Cinda. The Industrial and Commercial Bank of China is planning to list before the end of 2008, which is expected to result in another RMB700 billion ($85 billion) in NPLs being sold before the first quarter of 2006. The Agricultural Bank of China has also made it known that it is their intention to go public before the end of 2008 and introduce an even greater volume of NPLs into the market.

In fact, at the end of 2004, statistics from the government revealed that the balance of NPLs held by the big four and another twelve of the top commercial banks was about RMB17.2 trillion ($210 billion), which is more than the amount of RMB13.9 trillion ($170 billion) originally sold to the AMCs.

How banks and AMCs dispose of NPLs

A major concern of the government and, hence, the banks and AMCs is making sure that the sales of NPLs generates the highest possible recovery rates. Consequently, banks are prohibited by regulatory policy from selling NPLs below their book value. However, “settled” assets are not specifically covered under the regulatory provisions and this has created an opportunity for the banks to sell to entities other than the AMCs. Settled assets are physical assets such as land or buildings that are received as compensation to settle loans. Some banks, most notably the China Construction Bank in 2004, sold a portfolio of real estate with a face value of about RMB4.2 billion ($512 million) to Morgan Stanley and Deutsche Bank.

Nonetheless, AMCs have remained the primary vehicle for disposing of NPLs.

Other sales channels: secondary sales and securitizations

Generally, investors are much more willing to buy NPL pools directly from AMCs or banks. But it is also worth noting that a small secondary market has begun developing. For example, Alpha & Leader was able to assist one of its clients in acquiring a portion of China Orient’s first NPL pool from one of the eight foreign acquirers. Alpha & Leader had analyzed the pool and determined that there was hidden value and the client was able to make a substantial profit within 16 months of the acquisition.

Although securitizations as we would think of them in the West have not been achieved, AMCs have also been involved in “dirty securitizations”. In 2003, Huarong sold a portfolio with a face value of roughly RMB13.3 billion ($1.6 billion) utilizing a domestic trust company. In this transaction, an appraiser and rating company divided the portfolio into “preferred” and “subordinated” assets based on the expected future value of the cash flows from the assets. The trust company then sold trust certificates in “preferred” assets to domestic investors. Also in 2003, Cinda worked with Deutsche Bank on a portfolio of NPLs with a face value totaling roughly RMB1.6 billion ($193 million).  In April of 2004, the banks joined the securitization trend when Industrial and Commercial Bank of China worked with Credit Suisse First Boston on a portfolio with a face value of RMB2.6 billion ($314 million) and it is rumored that more of the “asset trust” deals are expected from the big four banks.

Nonetheless, there are a number of impediments to these transactions, including: the potential pool of obligators is limited by the previously discussed lending practices involving the SOEs (e.g., portfolios are concentrated with a few debtors, underlying loans are diverse, etc.); repayment streams are often unpredictable; creditors’ rights are in their infancy, securitizations aren’t specifically covered under PRC law and collections often rely on non-judicial means; and foreign investors face additional hurdles due to complicated and often confusing approval procedures and other structural obstacles.

The players

As seen from the table above, the magnitude of investment by foreign entities has been relatively small (around $6 billion) in comparison to total resolutions. In many respects this is not surprising since local investors have better understood the market, the underlying credits and are far more comfortable dealing with an ambiguous-at-best legal framework.

Nonetheless, since the opening of the NPL market in China, investment banks such as Citigroup, Morgan Stanley, Goldman Sachs, Deutsche Bank and CSFB have been actively purchasing NPL portfolios. The general consensus is that, as the investment banks have accumulated experience and set up local teams, they have in fact begun to see returns on their investments. However, as discussed below, obstacles remain and the next few years will be critical to both the investment banks and China.

Interestingly, beginning in 2003, many foreign funds began to play a direct role in the NPL market as opposed to working through the investment banks. Compared with investment banks, the funds have been much more aggressive in initiating deal flow and have demonstrated more flexibility in working with local partners. Reasons for this may include the fact that they recognize they are not as adroit in working in the local market, have smaller budgets and, out of necessity, have an enhanced since of urgency in closing transactions.


There is no official data on how much has been made on completed transactions. However, published reports suggest that they have been quite successful, with annual returns exceeding 25 percent. This would also seem to be supported by the anecdotal experience of firms such as Alpha & Leader. 

One Alpha & Leader client bought an NPL package for about RMB60 million ($7.3 million) and, within two years, had collected as much as RMB150 million ($18.3 million) in cash and other assets. One local investor purchased a portfolio for around RMB80 million ($9.8 million) and collected as much as RMB220 million ($26.8 million). In another instance, a local investor’s purchase price was RMB45 million ($5.5 million) and his return totaled RMB100 million ($12.2 million).  Clearly these are smaller transactions but the magnitude of the returns is impressive and in line with research reports. 

PricewaterhouseCoopers survey

In November 1994, PricewaterhouseCoopers conducted a survey among foreign investment banks, distressed debt funds and other commercial entities (around 40 in total). As stated in the report, the survey found that investors are committed to the market: nearly all the respondents expected to be involved for more than five years; all said that China is a high, if not top, priority in Asia; and, the vast majority believe opportunities will increase over the next three to five years.

At the same time, they are concerned with a number of trends: an unclear government approval process for proposed transactions; sellers re-negotiating sales terms; an unclear approval process within the seller’s organization; a lengthy timeframe to complete transactions; and, a lack of predictable deal flow.

A few final thoughts

The size of China’s NPL market is enormous and the PRC will need to continue to address this issue to insure both the growth necessary to ensure social stability and to shore up its banking sector in the face of competition due to WTO commitments to open its banking sector.  However, the fact remains that foreign investors have not been large players in the market and a significant portion of NPL reconciliations have been accomplished domestically through smaller transactions. 

For funds, this would seem to indicate that the road map for success would include:

Aggressively initiating transactions by expanding sources of local business referrals (e.g., lawyers, accountants, market participants, etc.);
Maintaining flexibility in establishing relationships with local market players (many of which have the appropriate connections but lack adequate capital); 
Building operations managed predominantly by top Asian professionals rather than expatriates as quickly as possible;
Providing excellent and appropriate training for local staff;
Developing technology processes, and systems suited to the unique requirements of China. Wherever appropriate, funds should adapt the best technology, processes, and systems from other regions; and,
Devising an entrepreneurial compensation system based on US and European models that treats managers as owners and rewards them for building value and earning profits in China’s NPL business.

Albert McLelland is a senior managing director of AmPac Strategic Capital LLC (AmPac). AmPac is a boutique investment bank that specializes in assisting foreign strategic and financial investors to build their businesses in China. Contact: Albert McLelland on 214-274-6525: email
Sunny Lin heads the Beijing office of Alpha & Leader Law Firm (Alpha & Leader), a law firm specializing in the non-performing loan market in China.  Contact: Sunny Lin on 8610 851-20881: email