China's banks withdraw from risk sectors

MANY ECONOMISTS - agree that Beijing will show “forbearance” toward China’s distressed corporate borrowers, but the same people also agree that Beijing will not be able to forestall a collapse of confidence should an unforeseen “black swan” event occur. For China, the “black swan” could come in the form of a fraud in peer-to-peer (P2P) lending or in China’s online payment systems, such as Alipay. A new scandal would almost certainly lead to destruction of consumer confidence, they say . . .

HONG KONG — In February, China’s biggest P2P lending platform, Ezubao, collapsed in what was described as a giant ponzi scheme  — some 50 billion yuan (US7.6 billion) is missing. Ezubao was established in 2014, roping in some 900,000 investors on the promise of higher returns.

That same promise has led to rapid proliferation of similar platforms throughout China. 
According to a report in China News, as of the end of 2015, P2P lending totalled US$150 billion (more than RMB982 billion). Since the Ezubao disaster, major Chinese banks have withdrawn support from the sector. Beijing has also stepped in, promising closer scrutiny of P2P lenders, but this has not stopped speculation that there are other potential P2P failures.

Ivo Naumann, a Partner with McKinsey &
Company in Shanghai, told a Hong Kong conference on distressed debt that the Chinese online payment system carries the risk of  (more) massive frauds. The conference of high level practitioners in distressed debt, bond issuance and investment banking, was organised by the international law firm, Latham & Watkins.

Naumann said that risk in the payment structure through vehicles operating outside China’s banking sector, like Alipay, has been building at a rapid pace.

“We do think that frauds in the Internet sector would massively impact on consumer attitudes inside China and would drive further defaults, he said. McKinsey is one of a number of global consultancy firms that has been charting the dramatic growth of China’s online economy for many years.

With China now relying increasingly on
consumerism to fuel its economy, Naumann
believes there is probably a bigger risk from the rapid growth of the Internet sector than from
distressed debt. Another major collapse of an
Internet platform would see the risk to consumer confidence increase. 

Another black swan could be a totally unrelated and unexpected event in some remote corner of the Chinese economy, where companies start to become insolvent and the flow-on impact cascades into the national economy.

US-based China commentator, Gordon Chang, a self-confessed China “bear”, told the conference: “The biggest black swan is the political problems that you have in China right now with the country’s number 1 (President Xi Jinping) and number 2  (Li Keqiang) leaders fighting each other.  We are seeing signs of intense political struggle.” Chang’s concern is that, because the Chinese leadership is preoccupied with political infighting, it could take its eyes off economic problems – and that is a threat to the Chinese economy.

Of immediate concern to speakers at the conference seemed to be the rising number of incidents of fraud in some financial transactions. Neil McDonald, a Partner in the Hong Kong office of the legal firm, Kirkland & Ellis, said there is a significant level of fraud in private equity in China. “If things get tight people (can) behave badly,” he said.

Also of concern, the conference was told, was the potential of fraud in the security or guarantees offered by Chinese companies in offshore transactions, like bond issuance.

Various speakers discussed the vulnerability of offshore investors in terms of the quality of security, guarantees and the attitude of the management of Chinese companies. They questioned the enforceability of the rights of offshore investors when an investment went sour. At the heart of debate over China’s
sharply rising debt problem is concern as to its
economic well-being around the world.

Unlike Thailand or Argentina, said Chang, who contributes to a number of publications, incuding Forbes magazine, China is not going to have a foreign debt crisis. “It is going to have a domestic debt crisis,” he said.

“When you look at history, the countries which have the hardest problem in getting through a debt crisis are not the ones which owe money to foreigners, they are the ones who owe money to themselves.” Until now, Chinese borrowers had been able to paper over financial problems by issuing
corporate bonds, usually high-yielding (a polite term for junk) bonds, he said.

China has witnessed an unprecedented boom in corporate bond issuance, which now totals US$3 trillion, according to a Bloomberg report.Chang claimed that 100 Chinese companies either cancelled or delayed debt issuance in April – and this was not a good sign.

According to Bloomberg, SOEs have started to default, triggering the biggest selloff in
onshore junk debt since 2014. Chinese issuers cancelled 61.9 billion yuan (US$9.6 billion) in bond sales in April alone, and Standard & Poor’s is revising downwards its ratings of Chinese firms at a pace unseen since 2003.

Kenneth Ho, Managing Director of Goldman Sachs, Hong Kong, told the conference that
defaults in China’s bond market started two years ago. “Now we are seeing much bigger SOEs having problems. The Government has forbearance in its back pocket. (But) it does feel that (the Government) is letting some defaults (happen).” Ho and other speakers said the fact that SOEs were being allowed to default shows that the Chinese Government is adopting a sensible approach to gradually allowing these companies to face their debt issues.

“If you are to improve the credit allocation process to make sure that resources are allocated
to more productive areas, you need to have
defaults. In a system where there is no default, capital doesn’t get allocated efficiently,” said Ho.

Goldman Sachs’ house view is that the size of China’s onshore bond market is about RMB15 trillion — of that, 2-3 per cent has defaulted and of those defaults, just 17 are “of a decent size”.

Ho said Beijing has to perform a balancing act — it has to deal with the stock of existing non-performing loans (NPLs) in a way that will not lead to widespread financial stress.

But doubt remains whether the invisible hand of the Government is behind the shoring up of some “favoured” companies.

Speakers noted that, in some situations, a month or two after the SOEs had defaulted in the public market, they were suddenly able to find money to repay debt — usually a week or two before the deadline. The funds could come from a variety of sources — maybe bank loans, direct Government injection, parent company, or shareholders’ assistance.

Seminar participants hoped that these supports would be gradually removed so that the market could assess risk appropriately.

Victor Jong, Partner, Business Recovery
Services, at PricewaterhouseCoopers (PwC) in Shanghai, described bond defaults as a “small step” towards addressing China’s overall distressed debt problem — because most bonds had implicit guarantees from Government or semi-Government entities.

As a result, debt was building up and there was over-capacity, said Jong. The upshot was the emergence of zombie companies — and this was not healthy.

Bondholders were anxious about the ability of issuers to honour their obligations because many bonds were unsecured, and, even for those with security, questions were being raised about the integrity of the collateral.

Neil McDonald said: “The question is: Can you work with the existing management and can you trust them to work with you — and that goes to the point about fraud.

“If you feel you cannot trust everything — but there is a management structure in place that you can work with to stabilise things and find solutions that work with stakeholders — that is the best option.”

“A consensual deal is a better way to do a deal in Asia. There are certain cases where you can’t trust management, and we have been seeing those in the recent past, and you then have a difficult decision.

“Do you use the tools available to you to break management control to tip the company into liquidation, for example, or do you have
securities appoint receivers?”

When a problem arises, much will depend on the leverage offshore holders have, and how
important the offshore assets are to the group as a whole, said Donna Duke, Director of Madison Pacific, a Hong Kong-based specialist offering a range of services, from trustee services to debt management. 

It is also a question of whether the offshore creditors can convince the onshore creditors that destabilisation from offshore actions will affect the onshore creditors’ position, she said.

“We all know that in most of these situations the onshore creditors are in a much stronger position than offshore creditors,” she added, saying that if onshore creditors could be convinced that offshore action would in some way affect their security value, then perhaps that would create a relationship where onshore and offshore creditors could work together.

Chinese companies are much bigger today, and the managements of companies with 30,000 or so employees have much greater clout than a smaller company.

The speakers agreed that, where once it might be sufficient to secure the agreement of the Chairman or the controlling family to back resolution of a debt issue, management of the large companies had to be involved. This added another layer of complication in negotiations.

Christopher Balding, Associate Professor of Economics at Peking University, said a backlog of NPLs is building up in the Chinese banking system — as yet not recognised as distressed debt. The definition of an NPL in China is different from the international classification.

Elsewhere a borrower is deemed to be in default 60 days after an interest payment is missed.  In China, there are five categories of loans under stress. As long as there is security, a bank can use discretion as to when to classify a loan as non-performing.

There is also what some call “moral hazard”.  Chinese lending managers can be penalised or sacked for writing bad loans, so they will keep rolling over a loan to avoid classifying it as distressed for as long as they can.

Donna Duke said the debt profile of some of these distressed companies is inappropriate, even for those which have a reasonable forecast of business activities. Many sectors, like coal, gas and oil, are seeing decreasing business
activity. “The question is: Just how long can they cover up for a bad loan and how many NPLs are being hidden?”

An analysis by the partly CITIC-owned CLSA brokerage in Hong Kong recently showed
potential for bad debt in Chinese banks at more than US$1 trillion — nine times more than official numbers indicate. Describing the problem as “endemic”, CLSA’s Head of China and Hong Kong Strategy, Francis Cheung, said NPLs stood at 15-19 per cent of outstanding credit last year. The official figure is just 1.67 per cent.

Gordon Chang believes that when all
debt, including shadow banking debt, is taken together, China’s true debt level could be as high as 400 per cent of GDP.

Standard Chartered Bank’s Shuang Ding, Head of Greater China Economic Research, agrees with the prevailing view that China’s corporate debt poses the biggest risk. The bank’s house view is that China’s debt level is 250 per cent of GDP, which is among the highest in the world, and, if the current trend continues, it may develop to 300 per cent of GDP.

“This,” he joked, “is where the (China) bull and bear could see eye to eye. (But) we estimate that the NPLs are not as bad as in the late 1990s, when distressed corporate debt fluctuated between 20-30 per cent of loans.”

Shuang said that because the public sector accounts for 10-20 per cent of China’s State assets, China can afford to carve off the bad loans.

Christopher Balding said: “The Chinese Government will show forbearance, but the problem will come if it accelerates in the wrong
direction. Unless the Government begins to
address the problem, eventually China’s
indebtedness will come home to roost.”

Balding agreed with other speakers that
Chinese debt is mostly denominated in RMB, and that, therefore, China’s debt problem is
essentially an internal credit problem. But if China moves to float the RMB, there would be a huge outflow of capital, threatening China’s
financial stability.

PwC’s Victor Jong said a debt crisis is unlikely over the next 12 to 18 months. “As long as the Chinese Government is in control, they will not allow a credit crisis to
become a full-blown problem.” He added: “The Government controls the internal (banking) system, so we do think it has a lot of levers available to deal with credit issues.  This is not to say that the credit
issues are not there; we just think they can be spread out over a long period of time.

“We think the ability and willingness of the Government to go into some kind of forbearance mode is very high. That is a more likely outcome then an immediate credit crisis.”

In the U.S., said Balding, there are 50,000 bankruptcies in a good year. A leading Chinese lawyer had told him official data shows that, in 2014 (latest available), China had 3,000-4,000 bankruptcies. “This tells us that they aren’t dealing with the (U.S.) level of problem.”

Apart from industries under most stress —coal and steel — many others are unprofitable and unable or struggling to pay their debt. A number of indebted companies are said to have been “hidden away for the last few years”.

But they cannot hide for much longer
because they are not going to be able to refinance in the Chinese bond market, according to some participants. Time is running out.

Chinese companies will be forced to clean up their balance sheets in a deleveraging process that could last three to five years.

Meanwhile, China will likely continue to print money — an option, according to some participants, when there are no other options. The danger of printing money was in asset bubbles, which, in themselves, could lead to “enormous” problems later on.

One to watch is China’s already heavily-indebted real estate sector. The Government has moved to prop up the market by removing some of the restrictions brought in earlier to cool overheating.

But the seminar heard that a crash in real estate will blow holes in the balance sheets of many companies.  Real estate is used as collateral in borrowings, and a collapse in value will cause China’s credit problems to manifest.

The overall impression of the participants was that China can hold off a full-blown debt crisis. Shuang said: “My view is that it is likely to be a painful adjustment.  But the Government still has the resources to solve the problem.  The sooner it can take action the less painful, the longer the more painful. “