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While Japan’s recession and its wobbly banks distract much of the world, the banking sector in China is in much worse shape. Xinhua News Agency has reported that central bank governor Dai Xianglong admits that nonperforming loans (NPLs) account for 26.6 percent of total lending by China’s top four state-owned commercial banks. As of the end of September, NPLs held by these financial institutions totaled 1.8 trillion yuan ($217 billion).

One estimate puts China’s NPLs at between $500 billion and $600 billion. Of this amount, four asset-management companies (Huarong, Great Wall Asset Management, China Orient Asset Management and Cinda Asset Management) are holding 170 billion yuan. Now the AMCs, each holding nonperforming assets of the four major banks, are beginning to seek foreign investors to buy some of the NPLs.

For its party, Huarong auctioned off 16.6 billion yuan of the NPLs it held for ICBC. Of this amount, 10.8 billion yuan worth of NPLs were sold to a consortium led by Morgan Stanley and including Lehman Brothers.

Great Wall Asset Management will also auction about 15 billion yuan worth of NPLs to international investors in April 2002. Xinhua News Agency reported that Orient Asset Management will sell between 15 and 20 percent of its 267 billion yuan worth of nonperforming assets to foreign investors for the Bank of China.

Instead of an auction, Cinda Asset Management signed an agreement with Goldman Sachs, Deutsche Bank and Lonestar Capital to dispose of its bad assets from China Construction Bank.

Things may be worse than they sound due to the fact that China substantially understates NPLs relative to international accounting standards. State-owned banks classify a loan as nonperforming only if interest payments have not been paid for two years.

By contrast, the international standard classifies bad loans as those that have not been serviced after three months. According to Ernst & Young, nearly half of all loans made by Chinese banks may never be repaid.

Despite various steps to recapitalize the largest banks and remove NPLs from their balance sheets, their overall health has not really improved. Instead of privatizing state-owned banks, China has chosen to recapitalize them.

According to People’s Bank of China (PBOC) estimates, restructuring costs of China’s financial sector have so far been about 2.5 trillion yuan (just under $302 billion), about 31 percent of GDP. This puts them in the upper range of past estimates that NPLs were 30 to 50 percent of total loans with restructuring costs of 25 to 30 percent of GDP.

Part of the plan to sort out the banks involved setting up debt-salvage companies to take over problem loans under the name of asset-management companies (AMCs) to conduct debt-for-equity swaps. China’s largest banks would be technically insolvent if they held their NPLs rather than shifting them to AMCs.

These serious problems in the banking sector persist despite the fact that 1.4 trillion yuan ($169 billion) in sour debt was transferred to asset-management companies in 1999, less than half of the $250-400 billion total of bad loans. Beijing offered estimates for a small decrease of 2.6 percentage points in the NPL ratio year-on-year by September.

With such enormous sums, it is not surprising that Beijing is hoping for some help from outside investors. The hope is that international financial houses that made profits from buying NPLs in other Asian economies will be tempted to bid.

However, it appears that Beijing’s expectations on sale prices are unrealistic. Whereas the international average for recuperation is 20 percent of face value of NPLs, Chinese officials have stated they expect the assets to sell for up to 30 percent. By contrast, distressed assets in Thailand and South Korea sold for as little as 10 cents on the dollar.

Even so, it remains unclear how foreign investors can realistically expect to collect on debts when state banks are unable to collect on loans made to state enterprises. As it is, Huarong has filed lawsuits against over 100 enterprises to reclaim around 107 billion yuan with little success. Lacking auditors, courts and laws relating to insolvency as well as secured creditors makes it almost impossible to force an enterprise into receivership. In 1996 there were only 540 bankruptcies in China, with even fewer in 1997.

Investors seeking to cash in on China’s fire sale are in for a difficult ride since transferring ownership to outsiders raises a number of sticky issues. Foreigners might expect to bring in management expertise and force enterprises to restructure so they could become profitable and repay their debts.

But none of this can happen unless they can gain a controlling interest to be able to force restructuring. As it is, state-owned enterprises face difficulties in letting workers go, replacing managers or undertaking technological upgrades. To make matters worse, land remains in the ownership of the state so that valuations of real estate will make no sense and property rights will be ambiguous.

There is considerable evidence that foreign investors have been overly sanguine about China plays in the past, often to appease Beijing. Such dishonesty does no one any good. Hopefully, bids in future rounds of asset sales will be more realistic and less opportunistic. Otherwise, it might be wise for shareholders and depositors in the foreign institutions to sell out quick.

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