China’s ‘bad banks’ back in the spotlight
A crumpled Chinese one-hundred yuan banknote is arranged for a photograph in Hong Kong, China, on Wednesday, Dec. 26, 2012. China's yuan fell for a fourth day after the central bank set the currency's reference rate at a five-week low amid concern budget deficits in advanced nations will hurt the global economy. Photographer: Jerome Favre/Bloomberg©Bloomberg
The prospect of the first ever default in China’s rapidly expanding shadow banking sector sent shockwaves through financial markets this year.
As word spread that a Rmb3bn trust product called “China Credit Equals Gold #1” was on the verge of defaulting, investors began to question the stability of China’s entire financial system.
But just days before the scheduled default, a mystery buyer bailed out the product, allowing investors to get back all the principal and most of the interest they were owed.
The Financial Times has learnt that the covert saviour, not publicly identified until now, was Huarong Asset Management, one of four “bad banks” set up in the late 1990s to deal with an enormous load of non-performing loans in the banking system.
More than five years into one of the biggest credit booms in history, Chinese banks are bracing for a fresh wave of bad debt that some analysts and economists believe could rival that of the late 1990s.
Companies such as Huarong are again expected to play a crucial role.
“As the economy slows, the market is expecting a further rise in non-performing assets,” said Harry Hu, an analyst at Standard & Poor’s. “We expect business volumes to increase for [Huarong and the other three bad banks].”
Signs of stress are already emerging as scores and perhaps hundreds of high-interest trust loans to risky borrowers run into trouble and China’s state-backed banking system struggles to avoid outright defaults.
So far there have been about 60 reported cases of trust product bailouts, but “in our opinion for every reported case, many unreported ones exist,” analysts at Bank of America Merrill Lynch wrote in a report last month.
Official data mask problems
Credit Equals Gold, which offered an annual interest rate of 10 per cent, was sold to investors by state-owned Industrial and Commercial Bank of China, the country’s largest lender.
Although ICBC was not technically liable for losses from the default, it came under huge pressure from the government and investors who had bought the product through its branches.
To bail the product out at the last minute, ICBC made a Rmb3bn loan to Huarong, which then bought the loan backing the trust product at about 95 cents on the dollar (95 fen on the Rmb).
That meant investors could be repaid almost everything they were owed and confidence in China’s shadow banking sector was restored, albeit at the expense of continued moral hazard.
Huarong’s plan to sell shares to global investors in an initial public offering, most likely in Hong Kong in the first half of next year, was probably the reason it was so keen to keep this arrangement quiet, according to people familiar with details of the bailout.
Huarong’s involvement in such an obviously political bailout would have undermined its argument to investors that it has transformed itself from an arm of the state into a commercial entity operating purely on market principles.
It has made that argument quite convincingly until now.
Credit growth
On Thursday, Huarong announced it had sold a 21 per cent stake for $2.4bn to a group of eight investors, including Goldman Sachs, Warburg Pincus and Malaysian sovereign wealth fund Khazanah.
Huarong’s upcoming IPO and its involvement in the bailout of China’s first big shadow banking default have pushed the spotlight back on to the role of China’s “bad banks”.
In the late 1990s, following a boom and bust in government-directed lending, China’s banking sector was technically insolvent, with bad loans making up as much as 40 per cent of lenders’ portfolios, according to independent analysts.
To deal with the problem, Beijing established Huarong and three other “asset management companies” – Orient, Great Wall and Cinda – to take Rmb1.4tn of bad loans off the banks’ books.
Non-performing loan ratio
The government then injected hundreds of billions of renminbi in fresh capital into the banks, sold stakes to foreign investors and eventually listed all of them in Hong Kong, although Beijing retains majority stakes and control of the lenders.
Before their bailouts, bank managers across the country usually gave loans according to orders from local Communist Party officials with little consideration for the ability of borrowers to repay them.
After they were listed, the banks became much more commercial and discerning in who they lent to.
But as China faced a collapse in growth in the wake of the 2008 global financial crisis, the government ordered banks to lend indiscriminately to prop up growth.
The effort to boost growth rates was successful, but it also resulted in one of the biggest and fastest credit expansions in history, with much of the money going to borrowers with an uncertain ability to repay.
Non-performing loan ratio, Q2 2014
In their half-year filings to the Hong Kong and Shanghai stock exchanges, China’s biggest banks all reported a surge in bad loans in the first half of this year.
At Bank of China, write-offs and sales of bad loans in the first half of 2014 totalled Rmb9.4bn, higher than the Rmb9.1bn for all of 2013.
The official non-performing loan ratio for China’s banks is at its highest level since March 2011, but it remains very low, at an average of about 1.08 per cent of all loans.
Agricultural Bank of China, which boasts 450m retail customers, is the worst-hit of the country’s big banks, albeit with a still-tiny bad loan ratio of just 1.24 per cent.
Bank executives and analysts say the banks use a variety of methods to understate the true level of their bad loans, including taking the riskiest loans before they go bad and restructuring them into off-balance sheet trust products such as Credit Equals Gold #1.
Big four aggregate net income
All of China’s biggest listed banks are trading below their book value – implying that investors believe that the loans on their book are not worth their face value.
As more loans go sour, Huarong and the other bad banks will be on the frontline of another Chinese banking clean-up.
They are already raising cash by selling bonds and equity – and taking large loans from a range of state-owned banks that they will use to buy bad loans from other state-owned banks.
The coming wave of defaults, particularly in the trust sector, will provide opportunities for these companies (and their investors) to profit from a process of bad loan resolution that they have become expert at over the past decade.
But it will also expose them once more to the kind of political imperatives and pressures involved in the bailout of Credit Equals Gold #1.