Chinese NPLs: Are the stars aligning?

“The level of domestic money and the demand for yield [in China] is crazy,” says the managing director of a non-Chinese NPL fund, quoted in a new report from the PwC Portfolio Advisory Group, asking whether the stars are finally aligning for Chinese non-performing loan opportunities.

On the face of it, there can be little surprise that the market is attracting attention from global investors. The report notes that China’s NPL stock in the commercial banking sector is worth a hefty $219 billion. Add so-called ‘special mention’ loans (overdue but not yet considered non-performing) and the figure rises to more than $700 billion – or nearly 6 percent of total loans outstanding.

But the MD quoted above claims to have given up on four deals in one quarter alone, having in one case agreed a price of 30 cents for every dollar of principal balance only for the seller to suddenly hike the asking price to 45 cents. Such experiences help explain why, over the past two years, only five recorded deals have been done by foreign investors acquiring NPL portfolios in China.

Pricing is a major problem. In the US and Western Europe, investors generally expect 15 percent-plus IRRs from distressed strategies. If they can get that level of return from markets considered to be relatively safe and stable, they will expect a premium from developing markets such as China. But only a handful of NPL portfolios in China are currently reaching 15 percent, with most in single digit or low double-digit territory. One major factor in this is that there are few forced sellers in China as the state remains controlling shareholder in most of the country’s listed banks and sole shareholder of nearly all its unlisted ones. This means little western-style political or shareholder pressure to offload bad loans to focus on more profitable activities.

The report also notes that China has a so-called NPL “merry-go-round” with local governments orchestrating bail-outs involving arranged sales at 100 cents in the dollar to sister entities.

However, the key to further activity for NPL funds could be continued steady weakening in the Chinese economy sufficient to jeopardise banks’ ability to meet annual NPL disposal targets. At this point, asking prices may fall and more attractive opportunities begin to arise.

The report notes one particular opportunity for foreign NPL investors: their ability to write large cheques. Few domestic players can compete for deals at the $100 million-plus level or are prepared to work for two years or more on acquiring a portfolio. This may explain why some pioneering overseas firms are now building ‘on the ground’ teams in the hope of having first-mover advantage as the stars begin to align.