Annual Review: Beauty and the beast in China

Everything comes at a cost, and some would say that the cost of China’s four trillion yuan ($582 billion; €552 billion) stimulus package in 2009 is the country’s mounting debt problem. The non-performing loan ratio of the country’s commercial banking sector reached 1.74 percent in 2016, with the value of total bad loans hitting 1.51 trillion yuan, according to the China Banking Regulatory Commission. Foreign investors are showing interest but the lack of information in the market means opportunities are limited to the courageous.

“For many years, it has been quite lonely for us. You can imagine before 2008, people who invest in China thought we were crazy because it was so easy to invest in real estate or growth equity and make easy returns,” Benjamin Fanger, founder of US-based fund manager Shoreline Capital, who has spent over 20 years in the country, tells PDI.

Shoreline is one of just a few investors in China that has been specialising in NPLs since 2004. The Chinese government set up four big asset management companies to handle NPLs in early 2000, but those have since changed from “bad banks” into multi-strategy financial companies.

But now the market is seeing more state-owned enterprise defaults and some corporates are suffering from over-leverage. This has made the banks uneasy and measures such as NPL securitisations and debt-to-equity swaps have been suggested by the government as a way of easing the pressure on balance sheets. NPL sales offer a fast way for banks to offload problematic loans, but there have been few successful deals.

“I would say the biggest challenge for NPLs is to price them accurately,” Fanger tells PDI. “Every loan in China has a different story, different collateral coverage and a different set of collateral documents that may or may not be enforceable.”

Unlike investing in listed companies, where investors have plenty of research and reports from different institutions at their fingertips, the market for NPLs is more obscure. The situation is further complicated by the local culture where most documents are in Chinese and investors are dealing with local SMEs. To price deals correctly, investors need to have a profound understanding of the Chinese market.

“Both the beauty and the beast of the NPLs in China is the low level of transparency,” says Eddie Hui, managing director, PAG, the Asian alternative investment management firm. “Only with that, can you have the opportunity to make big money.”

Some overseas investors have accumulated more experience since the first wave of NPLs in China. Asset managers such as PAG, which set up its Shanghai office in 2007, are showing an interest in the Chinese NPL opportunity. But even the enthusiasts recognise the difficulties.

“Pricing can be an issue even if you have found a ‘perfect’ portfolio, because the banks’ reserve price can often be significantly higher than what investors want to pay,” says James Dilley, a senior manager at PWC.

Investors and banks have very different commercial considerations. For the banks, selling a NPL means they have to recognise their loss. They are only willing to take this step when their balance sheets are under tremendous pressure. Even then, they will want to minimise the haircut.

For investors, with stated return requirements, their offer price will frequently be too aggressive for the banks to accept. In addition, Chinese banks have to evaluate the political risk associated with the sale of NPLs. If an NPL sold to a foreign investor generates a large return, the bank will be perceived to be giving away state-owned assets on the cheap, so banks are reluctant to sell to foreign investors at a large discount.

“Another challenge lies on the legal process of the transaction, if you look at an NPL, it looks nice, but whether you can put out your hands to grab it would be another problem,” says Hui.

Furthermore, regulations in China were tightened in the second half of 2015 to restrict investments in overseas stock markets and limit banks’ foreign exchange operations to reduce outbound investment. This has lowered liquidity for foreign investors wanting to invest in the Chinese market.

“You need to have at least a medium-term of view as to whether you are willing to deploy a significant amount of time and resources in the Chinese market,” adds Hui. “If you really want to get into this market, you need a sizeable and well-established platform with at least 10 to 20 people. When you are dealing with a credit investment of 100 million, you can ask one or two colleagues to handle it. But it doesn’t work when you have hundreds of loans coupling with hundreds more documents.”