Insufficient biz opportunities keep investors away
By Zhang Dingmin (China Daily)
Updated: 2004-05-10 08:55

In the numerous discussions in recent years about China's banking system, cutting out the huge amount of bad assets has been a major topic.

And Chinese banks and asset management companies (AMCs) have pinned high hopes on the approach of selling them to international investors.

The need for foreign participation in the market is growing as the banks endeavour to clean their balance sheets in preparation for public share offerings the climax of their reform blueprints.

But some foreign investors are already losing enthusiasm, warns Ernst & Young, which has been involved in major deals with foreign investors, after seeing that the market has not yet generated the business opportunities they had expected.

Jack Rodman, partner and managing director of Ernst & Young, transaction advisory services, said: "There are so few transactions that some of my investors are stepping back and saying, 'Jack, we might wait out a year or two. We are not seeing enough transactions to do business here.'"

While China's four AMCs have disposed of one-third of the 1.4 trillion yuan (US$168 billion) of non-performing loans (NPLs) that they took over in 1999 from the State-owned commercial banks largely by restructuring with borrowers, their achievement in international sales specifically has been less satisfactory.

Only five such deals have been approved or completed in the past few years, out of a dozen or so signed so far, which is slow compared to many other markets.

It took Huarong, one of the AMCs, 14 months to get regulatory approval last year for its first international NPL auction.

And regulatory approval for a joint venture (JV) between the China Construction Bank (CCB) and Morgan Stanley, announced last year, is on hold, according to Rodman.

"The approval process for these pilot programmes takes too long," he said.

The law in China prohibits commercial banks from entering into JVs with foreign investors, or selling loans under book value.

And there are other legal uncertainties surrounding such pilot efforts, such as unclear tax liabilities.

But the legal barriers are not the biggest problems hindering the approval process, said Rodman, who advised during both of Huarong's two international auctions and is currently working on an international sale of settled assets by the CCB.

"The biggest concern I have today with the NPL business in China is a very high level of fear for individuals to approve a transaction," he said.

Rodman said he felt a widespread reluctance among not only officials at banks and AMCs, but regulators for fear of being criticized for selling State assets cheaply to foreigners. "This is the biggest impediment to having a robust foreign investment market in distressed assets in China."

"The fear I have is they (foreign investors) pick the money and go to other markets. And that's what happened in the Philippines, in Thailand and in Indonesia, because the investors cannot get their money out."

Officials with the China Banking Regulatory Commission, the Ministry of Finance and the People's Bank of China were not available for comment, but AMC managers largely agreed.

"I think such worries (as selling assets cheaply) are not rare," said one AMC official, who refused to be named.

He acknowledged that there was a "pricing problem" at AMCs due to their incomplete pricing systems and asset appraisal methodologies.

"We tried our best to ensure the maximum recovery for every transaction, but that doesn't guarantee that others think the same way," he said. "But if we don't sell, people will say we are not efficient."

Last week, it was reported that a sale by the Bank of China's Guangdong branch was cancelled. The transaction was announced earlier this year.

"No country anywhere in the world has been able to successfully reform its financial markets and rid its system of bad debts without the aggressive participation of foreign investors," Rodman said.

"At the present time many are moving to Germany where, in the last year, over US$1 billion was invested in NPLs."

Huge amounts of distressed assets are poised to flow into the Chinese market in the coming few years, analysts say.

The AMCs plan to dispose of the rest of their NPLs by the end of 2006. And the four State-owned commercial banks alone need to tackle a staggering 1.89 trillion yuan (US$227 billion) of bad loans, which were still on their books at the end of March.

But Rodman is worried that not much of the cash will flow to foreign investors, who are ready to invest.

The AMCs are likely to become more cautious when approving new auctions as they are now required to meet a minimum recovery target under a new policy approved earlier this year.

And the regulatory permission for them to reinvest in the sour assets and purchase more distressed assets from commercial banks another key part of the new policy threatens to marginalize foreign investors.

"Who would they (the banks) prefer to do business with given the fear of being criticized?" Rodman asked. "So you are going to kill the market."

The best way, Rodman insists, is for AMCs to sell assets to and form JVs with foreign investors who have the necessary expertise, which can provide the highest recovery value when foreign investors bid up the price to win the deal.

Selling distressed assets to foreign investors is a highly sensitive issue in China, where corruption and other irregularities have made the "drainage of State assets" a frequently heard phrase.

While there have been suspicions that the AMCs have been dumping their worst assets to foreign investors, they are more frequently dogged by accusations of selling their assets at low prices to meet resolution targets.

Last month, State auditors started a half-year audit on the four AMCs, the first full-scale inspection since their establishment in 1999.

There is no easy answer to whether some assets have been sold too cheaply, or otherwise, with both sellers and buyers keeping their lips tight and the assets still being recovered.

But Rodman says there are ways to ensure fair pricing.

"Firstly, you hire a reputable experienced financial adviser. Then, you hire advertisers to promote the transaction around the globe to attract investors," he said.

"Thirdly, the process becomes fair. There is no corruption, there are no payoffs. It is totally fair and independent. Fourthly, we give an opinion of value on the portfolio."

That approach, which Rodman said was the way Huarong's international auctions were executed, will ensure that eager investors pay the highest price possible.

The average price to bid on a portfolio, in terms of due diligence, is close to US$500,000.

"I assure you they want to win. And to win, you have to pay the maximum price," Rodman said. "If somebody outbids you by one dollar, you lose and he wins."

The transaction can be cancelled if the bids come in too far below the target, and the seller has the right to share the upside if the final recovery value far exceeds the price.

The prices foreign investors paid were reportedly lower than the cash recovery ratios the AMCs reported, which fuelled scepticism that the assets were sold cheaply. But Rodman said the two were not comparable as AMC recoveries do not reflect the time value of money because they exclude the cost of things like human resources and office buildings.

And investors expect a higher risk premium than in some other Asian countries, like Japan, as compensation for the relatively high risk of investing in China's immature distressed debt market.

"In Japan today, they are happy to earn 15 per cent. In China, they want to earn 20 to 25 per cent," Rodman said.

But like in those mature markets, the seller will eventually get a higher price when the risks drop and more foreign investors come in to bid up prices, he said.

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