Ernst & Young, a leading international consulting service provider, released a report earlier this week on the global non-performing loan (NPL) situation. The following is an abstract of the report's China section.

Among Asian nations that have sold large NPL portfolios, China is a relative latecomer to the market. Not until 2001 did China Huarong Asset Management Corporation complete the country's first-ever NPL portfolio sale to foreign investors, Goldman Sachs and a consortium led by Morgan Stanley including Citigroup and Lehman Brothers.

Since that landmark transaction, China's NPL market has been relatively quiet. In fact, a total of eleven portfolios have transacted, of which seven are still in processing, pending approval, or have been cancelled outright.

Although disposal of sizable NPL portfolios to global investors has been slower in China than in other Asian markets tracked by Ernst & Young, market activity appears to be picking up, and global buyers are beginning to see more investment opportunities in the world's second-largest market (after Japan).

We anticipate NPL deal flow will increase in 2004 and beyond, driven by China's need to develop a more efficient banking system, and the banks' need to reduce their NPL holdings, clean up their balance sheets, and improve their credit ratings all necessary steps to prepare China for opening its domestic banking market in 2007 to foreign banks as part of its World Trade Organization (WTO) commitments.

Encouraged by China's central bank, China's four largest state-owned commercial banks or the big four banks (Industrial and Commercial Bank of China, Bank of China, China Construction Bank, and Agricultural Bank of China) aim to reduce their combined NPL ratio (total NPLs to total loans) to an average 15 percent by 2006. With a present NPL ratio of just under 20.36 percent according to the Chinese Government, they appear to be on track to reach their 15 percent target in just two years.

If the big four can do even better and reduce their NPL ratio to less than 10 percent, they could not only compete more effectively against foreign lenders but also might meet threshold requirements for public listings on foreign stock exchanges.

Banking industry

In 2003, China's big four had an average NPL ratio of 20.36 percent. While this was an improvement from 2002's ratio of 26.1 percent, many in the banking and finance community attribute the reduction to a substantial increase in new loan issuances.

In fact, the ratio of total outstanding loans to GDP jumped from 1.17 in 2001 to almost 1.47 at year-end 2003 an all-time high.

Although an increase in the banks' loan volume has reduced their NPL ratio, they have achieved a real reduction in actual NPL amounts. In 2003, the four State-owned banks had aggregate NPL amounts of 1.92 trillion yuan (US$232 billion), down from 2.2 trillion yuan (US$266 billion) in 2002.

Of the four banks, China Construction Bank (CCB) is leading the charge in reducing NPLs. At the end of 2003, CCB had distressed loans of about 193 billion yuan (US$23.4 billion) or just 9.25 percent of its total loans.

Bank of China (BOC) was second with total bad loans of 344 billion yuan (US$41.5 billion) or about 16 percent.

While the remaining two banks were laden with over 700 billion yuan (US$85 billion) each, the Industrial and Commercial Bank of China (the largest among the big four) will find it easier to dispose of its assets since its lending is more diversified (by asset type) compared to the Agricultural Bank of China, which has substantial monies tied up in rural properties where supply and demand are disproportionate.

In addition to the reduction in NPLs in 2003, the banks' overall financial situation is improving in other ways. In January 2004, the China Banking Regulatory Commission (CBRC), the banking industry's governing body, which sets regulations and conducts routine management reviews, announced that it had injected US$45 billion of China's foreign-exchange reserves into CCB and BOC.

Both banks are racing to complete initial public offerings and the government's funds could possibly enable the banks to write off bad debts or improve capital adequacy ratios.

We see this capital injection as just the first step in a larger government plan to overhaul the big four, with more substantial capital injections expected in 2004 and 2005.

Other regulatory modifications will increase foreign competition and participation in the banking system. In December 2003, the CBRC announced that single foreign banks can have up to a 20 percent strategic interest in a Chinese bank.

Additional government reform strategies could include China's central bank buying NPL-backed bonds issued by the banks, creation of "good" and "bad" banks, or another transfer of NPLs to China's four asset management companies (AMCs).

The CBRC reportedly plans to issue quarterly non-performing loan data for the bank sector using more stringent criteria. It already has announced that the banks are required in 2004 to use a new five-category loan classification system, which is based on a stricter, internationally accepted standard.

The tighter measures are part of a larger plan to prepare the state banks for public offerings.

Despite progress in reducing its NPLs and recent regulatory changes, China continues to face the issue of instituting long-term banking reform.

Based on our big four experience, the banks' head offices have educated and capable leadership with access to sophisticated risk management techniques, and we concur with other independent observations that these techniques should be applied.

Four asset management companies

Upon their establishment in 1999, China's four largest AMCs - Cinda, Great Wall, Huarong, and Orient - acquired NPLs totaling 1.4 trillion yuan (US$168 billion) from the big four.

These AMCs are expected to dispose of their entire NPL portfolios by 2009. At present, they are typically resolving their NPLs through revised repayment plans with borrowers, discounted borrower payoffs, collateral sales, and selling assets to third party investors (either as single asset or portfolio sales).

Most third party NPL buyers and AMCs are disappointed with their results to date in China. The AMCs are frustrated that senior management and regulators must give approval to pursue multiple transaction strategies.

In many instances, internal approvals of NPL transactions require several months and regulatory approvals require additional time too. Buyers who came to China to pursue NPL transactions are disenchanted with the lack of sustainable or predictable deal flow.

These buyers, plus third party service providers who anticipate working on these transactions, must wait and see if the AMCs have been persuaded enough to sell a portfolio of assets.

Buyers also are concerned that the AMCs often provide inconsistent or incomplete information about NPL portfolios or are unable to produce key legal documentation. Not surprisingly, this has made buyers more conservative about asset pricing.

AMCs have been slow to offer large portfolios for international auction for two reasons. First, if assets were sold in bulk on a regular, consistent basis, the AMCs would finish disposing of assets faster and AMC employees believe they would be out of work that much sooner.

Second, the branches have a powerful voice within the AMCs. Some branches use this power to push their head offices in Beijing to unload the worst-of-the-worst loans, whereas other branch locations fully embrace bulk auction sales as an effective means to resolve nonperforming assets by offering portfolios containing a reasonable mix of both good and bad assets.

Instead of auctions, many AMCs would prefer to negotiate private transactions with buyers. But they fear that without the competitiveness of an auction format, they cannot obtain the necessary regulatory approvals. While there are merits for auctions and negotiations alike, both require time-consuming regulatory approvals.

Overall, the AMCs have not fully embraced either strategy. Some AMCs note that their local branches prefer to engage in transactions directly with domestic buyers instead of with foreign firms. Reportedly, these local entities pay higher prices for the assets.

However, many of the AMCs complain that these domestic transactions are subject to endless negotiations with the buyers and complain that closing periods are unnecessarily long.

Domestic transactions with local branches also raise issues with respect to transparency a trade-off to selling to international buyers at market clearing prices.

In many instances, the AMC continues to service the assets on behalf of the domestic buyer. This causes analysts to question if a sale was even accomplished, or if the buyer merely advanced a cash deposit against assets the AMCs resolve on their behalf.

AMCs conclude that while there is a legitimate role for branches to conduct domestic transactions, such transactions are simply too small and too infrequent to achieve the AMCs' annual NPL reduction goals.

Nonetheless, the AMCs' numbers are showing improvement. Total resolutions since 1999 have been about 509 billion yuan (US$62 billion). Their NPLs totaled approximately 885 billion yuan (US$107 billion) at the end of 2003.

While the AMCs have gained valuable resolution experience since their establishment in 1999, their recovery amounts are based on the earliest recoveries of total assets - or nearly three years of active collections.

Although the recovery amounts are relatively attractive, many of these figures are based on assets which were highly collectible in proportion to the amount of effort (time and costs) needed for the recovery.

It is important to note that we could not verify if these figures are based on future negotiated repayment terms or if they truly represent actual cash receipts.

Notable NPL transaction

At the beginning of 2002, there were high expectations that the big four and AMCs would accelerate their disposal of NPLs after the country's first-ever NPL portfolio sale to foreign buyers.

However, they had to wait to see if the Huarong transaction would receive the necessary regulatory approvals. It finally did, but by then it was 2003, and during spring and summer the SARS virus hindered the NPL market and most business activity in China. Since the landmark Huarong sale, the vast majority of transactions have been smaller trades of loans or settled assets at the (big four or AMC) branch level. Due to the size and nature of these single deals, our detailed findings do not reflect such activity.

Outlook

Will the big four meet the target of the People's Bank of China (PBOC)? It seems likely they will meet their target NPL ratio of 15 percent by 2006, a target set by the PBOC. (As previously noted, the banks will need to further reduce their NPLs to less than 10 percent to qualify for listing on foreign stock exchanges.)

This assumes the banks continue to reduce NPLs and do not take on any new NPLs, and the government continues to make capital injections into the banks.

Furthermore, aggressive NPL resolution strategies such as large, consistent (perhaps quarterly) dispositions are still vital to make the banks more efficient and attractive investment vehicles.

As we have witnessed in the Republic of Korea and Taiwan, active management practices will always win over passive complacency.

Will there be a second transfer of NPLs from the banks to AMCs? We believe the big four would favor a move by the PBOC and the Ministry of Finance to fund a second round of bank NPL sales to the AMCs.

This is clearly the fastest way for the banks to lower their NPL ratio to acceptable international standards without diminishing their minimum capital adequacy ratio of 8 percent (required to meet the standards of the Bank of International Settlements).

Other alternatives include allowing the banks and their corresponding AMCs to establish a joint venture for the disposition of NPLs or establishing "bad banks" whereby the banks' nonperforming assets are placed into these entities and resolved separately from the "good bank." If NPLs are left on the banks' balance sheets, continuing NPL losses will impair capital adequacy.

Because of these complexities and lack of a painless, clear-cut solution, there is no single correct path to follow. The pressures within China's banking system as it converts from a planned economy to a capitalistic market will ultimately force stronger and faster NPL dispositions.

Having made huge capital injections into two of the big four early in 2004, the government undoubtedly will be looking to both the big four and AMCs to accelerate their NPL dispositions.

In addition, the four banks are under pressure to clean up their balance sheets and recapitalize in preparation for initial public offerings, and we are cautiously optimistic that they will bring more NPL portfolios to the market in 2004 and 2005.

Presently, both CCB and ICBC are processing joint ventures with foreign investors, which could lead to more such transactions when these two pioneering ventures are finally approved.

With a mix of both failed and successful transactions to date, the banks are gaining a clearer understanding of transaction procedures and international standards while buyers are becoming more comfortable with asset types and legal processes.

The banks are believed to possess better quality NPLs than those transferred to the AMCs, and accordingly, many investors are looking at them as a primary source of NPL deal flow.

For their part, the AMCs believe they are most qualified to resolve NPLs on behalf of the government and banking system and are best positioned to take another transfer of NPLs from the banks.

To retain their exclusive position, the AMCs are expected to increase their transactions with the banks in 2004/05.

China is already seeing the tremendous economic benefits of free market trade, but internal bank reform and the establishment of proven corporate governance mechanisms are also important for the banks to prevent the economy from overheating.

Additionally, adopting the latest in credit management techniques will enable the big four to better compete with the looming influx of foreign competition.

If China begins to steadily face its inevitable growing pains (in disposing of large portfolios of NPLs), it can successfully reform itself and focus its efforts on becoming the world's biggest economy.

(China Daily March 26, 2004)