Going Bust

Overcoming a Dysfunctional Credit System in China

William Gamble

WILLIAM GAMBLE is a lawyer and a principal of Emerging Market Strategies, a

firm specializing in legal risk management in emerging markets.

Lenders all over the world have the same problem: how to get debtors to pay them back. Basic game theory dictates that in interactions between a lender and a debtor, the debtor's best strategy is to default. Of course, lenders know this, so often their best strategy is not to make the loan at all. Despite this obstacle, loans are made. Lenders use various means to ensure repayment. In emerging markets, social norms with second and third party enforcement are popular.

This explains the prevalent practice of lending to friends, cronies, and guanxi (connections) without formal credit analysis. Physical force or intimidation can be effective, but it requires a personal touch. Besides, these methods are useful only on a small scale.

Far more economically efficient--according to the Coase theorem--is a functioning legal system with low transaction costs. Such a legal infrastructure must include laws, a functioning and unbiased court system, lawyers, enforcement, and a central registry where title and security interests can be determined. All of these elements must be free of government interference. Officials must have sufficient incentives and disincentives to perform their functions in a reasonably honest manner. Although the legal infrastructure is the cheapest component of a state's overall infrastructure, it is the most neglected.

This neglect is not an oversight. It is often part of policy. Laws, procedures, and property rights, while essential to a market economy, often restrict government power, specifically the power to allocate capital to wherever the government sees fit. The misuse of this power has been an economic disaster throughout the world, especially in Asia. Financial and banking systems have been crippled and will require massive bailouts at taxpayer expense--assuming there are taxes to expend. China barely collects 14 percent of gross domestic product (GDP) in taxes, which is meager compared to the 2001 takings of Japan (27 percent), the United States (29 percent), and the United Kingdom (37 percent).

Non-Performing Loans

Pillaging of the financial system has created enormous mountains of bad or non-performing loans (NPLs). They will probably never be paid back for a variety of reasons. The Chinese cannot pay back their debts. On the other hand, the Japanese do not want to: while most bank regulators try to keep banks from making imprudent loans, in Japan, the Financial Service Agency "has been pressuring the bank[s]to do just the reverse--or keep the funds flowing to borrowers the bank[s'] own credit department regards as dodgy," as Akio Mikuni and R. Taggart Murphy comment in Japan's Policy Trap: Dollars, Deflation and the Crisis of Japanese Finance. Malaysia, Thailand, and Indonesia cannot repay their loans because they are hobbled by ineffectual legal systems.

The numbers of NPLs inspire awe. In China, the official estimate of bad loans is US$406 billion, although a more realistic estimate would be US$518 billion. Most of these bad loans are concentrated in the four main state banks: Bank of China, Industrial and Commercial Bank of China, China Construction Bank, and Agricultural Bank of China. The worst offenders are the Construction Bank and the Agricultural Bank, where the NPLs are estimated to be approximately 40 and 80 percent respectively of total assets. Conservative estimates list Japanese debts at US$358 billion. The actual amount of questionable loans may be much higher. The criteria used in both China and Japan are less stringent than in the United States, even assuming that the amount of the loans has been accurately reported.

These bad loans are the result of three things: people, policy, and practice. In 1997, a new concept, crony capitalism, emerged. A less pejorative and more descriptive term for this particular problem would be "relationship lending." In parts of Southeast Asia, certain loans were made to favored cronies of government officials. More often, these cronies loaned money to themselves through banks that they owned.

In Japan, loans usually went to companies with which the bank maintained a relationship, often within the bank's keiretsu group, which is a uniquely Japanese grouping of affiliated companies that work together in close alliance. In China, the relationships, or guanxi, were determined by the local Communist Party. Most of the salaries, wages, and often government revenues come from a local state owned enterprise (SOE). The fact that these enterprises are often insolvent makes little difference. They were, and to a great extent still are, the principle recipients of loans from the four main state banks.

The second origin of bad loans has been policy lending. Regardless of the credit risk, governments throughout the world have encouraged banks to lend to industries favored under government policies. In China, the worst example is Angang, the steel giant based in Liaoning province. A showcase of the modernization for steel production in China, the company is a favored destination for loans even though it is not profitable. The same is true for Japan, where the Ministry of Finance, with its dirigistetendencies, guides loans to favored companies without reference to credit risk.

In environments where loan recipients are not chosen by financial risk, it is not surprising that good banking practices are noticeably absent.[PQ?] With very few exceptions, China's lending institutions are owned by the government. Good corporate governance, prudent operations, transparency, and even profit are not high priorities.[PQ?] Their main purpose is to channel funds to favored people and enterprises, usually local ones. As a result, it is not surprising that some of the money goes astray. In one case, US$483 million was embezzled in a Bank of China loan scandal. This theft reached the highest levels of power, with culprits including Wang Xuebing, a former chief of the Bank of China.

Even without theft, some of the most basic banking practices are ignored. Loans are not always documented. Collateral is not requested, and even when it exists, the procedures necessary for the bank to gain a legal interest in it are not properly followed. The absence of a legal environment that prohibits government interference and discourages prudent practice can have a devastating effect on both the financial system and investments. Governments can support their programs in two ways. They can spend taxpayer money or depositor money through loans from banks. Taxpayer money is preferable, since it does not have to be paid back. If depositors are not repaid, they have a history of creating financial panics, while taxpayers just complain.[PQ?]

Besides the possibility of provoking a deep depression, the accumulation of bad loans has several other adverse economic effects. Unresolved NPLs are an indicator of an inefficient allocation of capital within the system. They discourage new loans to healthier segments of the economy. Bad loans need to be cleaned out by the plumbing of market economies, an efficient bankruptcy system. If they are allowed to stagnate on the banks' books, the rot could spread to the rest of the economy, as it has in Japan.

Systemic Stagnation

Unfortunately, China does not have an efficient bankruptcy system. Its 1987 Bankruptcy Law is out of date, limited to SOEs, and not enforced. According to a senior Chinese official, legislating a new law could take another five years. The reluctance is understandable. Bankruptcy is unpalatable to everyone (except creditors, who at least get something). In China, this means that managers--often Communist Party members--are out of work. Investors, usually the Chinese government, have lost their money, and workers without jobs can foment social instability.

Rather than risk bankruptcy, the Chinese have tried to imitate a US solution to their banking crisis. During the savings and loans banking crisis of the late 1980s, the US federal government created the Resolution Trust Corporation (RTC). Usually the RTC would guarantee depositors' accounts in exchange for the NPLs of an insolvent bank. Once the RTC had title to the loans, it would foreclose on any collateral and sell it as quickly as possible. The bank would be closed, the depositors would be paid off, and the difference between the value of the collateral and the liability to the depositors was borne by the taxpayer.

The Asian version of the RTC has one major difference: in China, Asset Management Companies (AMCs) were established, and in Japan, the government created the Resolution and Collection Corporation (RCC). However, neither the AMCs nor the RCC have the power to close an insolvent bank. Instead, they only purchase the bank's bad loans, while the bank and its management, who are responsible for making the bad loans, remain. The incompetent bankers are left to continue their profligate ways.

The main difference between the AMCs and the RCC is price. The RCC is supposed to buy dud loans at "market price," a fraction of the original amount of the loan. In contrast, the AMCs purchase bad loans from one of the corresponding big four banks at face value in exchange for 10-year bonds. The bonds pay 2.25 percent per annum, which is often better than the yield on the underlying loan. So, in theory, the banks' balance sheets have been wiped clean. Instead of holding bad loans as assets, they hold the AMC interest-bearing bonds.

The reality is quite different. The bonds are not guaranteed by the government. In order to repay the bonds and pay the coupons, AMCs must collect 100 percent of the value of the bad loan and interest. "Nobody knows where [the AMCs] will get the money to pay the IOU at maturity--that depends on whether the AMC can create something out of nothing," laments John Langlois of theAsian Wall Street Journal. The only party that actually benefits from this transaction is the government, as the interest paid by the AMCs to their corresponding bank is taxed.

Whatever their deficiencies, the AMCs were set up, and in 2000, 1.4 trillion renminbi (RMB) (US$170 billion) worth of bad bank loans were transferred. This was supposed to solve the problem, but it did not. Rather than restraining their lavish lending, the banks just kept making bad loans after the transfer. In 2002, a further RMB 400 billion (US$50 billion) worth of new loans were made, which accounts for more than 4 percent of GDP. The People's Bank of China (PBOC), China's central bank, has claimed that the NPL ratio fell 4.6 percent in 2002. However, it did not state the amount of the bad loans, which may have remained constant. The reduction may be the result of a larger number of loans. Besides, the main originator of bad loans, the SOEs, increased their debt by 3.1 percent.

The AMCs proved no better at collecting the NPLs than the banks. The deficient legal infrastructure, which encouraged the banks to make the loans, makes it impossible to get rid of them. Creditors have four alternatives for disposing of a bad loan: they can try to collect the loan (or at least the collateral) from the debtor, force the debtor into bankruptcy, exchange the debt for equity in the debtor's enterprise, or, least likely, sell the loan.

An Unworkable Solution

Collecting a debt is almost impossible in China. Since state banks lend to state companies, there are often no records, collateral, mortgages or security interest. Even good collateral with a legally enforceable security interests is hard to find. Managers of SOEs often strip assets and transfer them to their own private companies.

Local courts protect local companies, because they usually report to the same local cadres. According to a famous Chinese legal commentator, Cao Siyuan, there is less than a 0.1 percent chance of winning a case against the local company, whatever the merits of the case. In one instance, cited by Richard McGregor in the Financial Times, when a local loan shark used local judges as well as muscle to enforce a debt, the "judges told him not to worry about repaying his official loans, 'as [the banks] can write off debt.'" But the man had to pay back the loan shark, at the risk of the courts destroying his family.

Since China does not have a functioning bankruptcy system, AMCs and banks have occasionally tried to solve the problem by exchanging the debt of an SOE for equity. Although in theory this gives the bank or AMC the power to restructure the SOE, in reality, nothing changes. Before the transaction, the SOE is 100 percent state owned. After the transaction, the SOE is still 100 percent state owned. The bank or AMC may not have the power to change management, fire workers, or even shut the company down. Even if the company had the potential to realize a profit, there is very little that the lender can do to bring about the transformation.

The most optimistic method to dispose of the loans would be to sell them. Alternatively, AMCs and banks have tried to either sell the underlying collateral or even the stock that they received in exchange for debt. Recent attempts to auction off assets have not been very successful. On June 3, 2002, a state bank kicked off an "auction week" of its bad assets in 60 cities. It tried to auction off RMB 3.3 billion in assets (US$402 million). The auctions only yielded RMB 305 million (US$37 million), or about 9 percent of the target earnings.

Since foreign investors will almost always invest in anything Chinese, they were selected as the potential buyers for the NPLs. The Chinese put together a roadshow, where a portfolio of RMB 1.4 trillion (US$169 million) was presented to 200 institutional investors; 16 expressed interest and just seven bid. Only one "bid" was accepted. In December 2001, it was trumpeted that Morgan Stanley, a US investment bank, purchased some of the NPLs for 9 perent of face value.

The reality was different, as the structure of the deal became apparent a year later. A consortium led by Morgan Stanley and another led by Goldman Sachs had agreed with two AMCs to form joint ventures, which were to "focus on tackling their bad assets through sales, agreements with debtors, and auctions." There was no mention of any sale, payment to the AMCs or transfer of title. Morgan Stanley and Goldman Sachs own 70 percent and 65 percent of the joint ventures respectively. The US companies have only a contingent interest in anything they can collect.

The expected recovery is 20 percent. The consortiums might look at a little history and pay more attention to the legal infrastructure surrounding their investments. For example, after three years, the recovery from the infamous collapse of Guangdong International Trust and Investment Corporation has been only 2.3 percent.

In January, the PBOC met in Beijing to try to find a way to reorganize the banks and reduce the NPLs. Solutions include another huge recapitalization, transferring another large tranche of NPLs to the AMCs, splitting up the banks, and selling their stock to foreigners. Subjecting the power of the communist government to law was not mentioned. The new governor of the PBOC said that, "Dealing with this problem needs new thinking." Apparently, none was available.