China's Good, Bad And Ugly Bank Loans

China appears to have recovered more quickly from the global financial crisis than most other major economies, thanks to a credit stimulus program that saw banks extend 9.6 trillion yuan ($1.4 trillion) in new loans last year -- more than twice the total lending for 2008. But as the rest of the world starts to recover too and Beijing itself tries to scale back credit explosion, a new set of questions is emerging: Will China have to pay the piper for this windfall of lending, and if so, when and how? And will this create opportunities for foreign investors?

The obvious place to start is the danger that banks will be stuck with a growing number of nonperforming loans as borrowing beneficiaries of the stimulus struggle to pay back the money. History shows that following massive upticks in lending, a greater-than-normal level of NPLs follows. During lending sprees, credit underwriting standards naturally get relaxed and companies that ordinarily might not qualify for loans manage to obtain them. Credit-rating agency Standard & Poor's recently estimated that China's bad loans would reach 1.8 trillion yuan to 2.7 trillion yuan over the next few years, nearly five times greater than the amount reported for 2009.

Depending on how Beijing resolves the situation, an increase in bad loans could present opportunities for foreign investors. The last time the government fixed the banks, starting in the late 1990s, it created special asset-management companies (AMCs) to acquire the bad loans of the nation's largest banks. The AMCs started to sell portfolios of NPLs and foreign investors were quick to invest in them.

Getting rid of the loans was good for the banks and good for investors. The banks were able to recapitalize and begin a modernization process that has led to three of the big four banks ultimately listing, with the fourth, Agricultural Bank of China, slated for later this year. Meanwhile, investors profited for a while, often by offering to settle up with debtors for cents on the dollar, something the banks were not allowed to do. But over time, many foreign investors grew tired of investing in China's NPLs, as closing deals became difficult and the inventory of bad loans dried up.

In some respects the circumstances of last year's credit expansion are similar enough that foreign investors might hope for another opportunity to get back in the game. Many of those bad loans will indeed take a traditional form -- a company that simply can't pay its debts anymore. But in this case, China may also see an exotic twist that should give pause to prospective investors: One probable source of bad debt will be loans to government-related sponsors of public-works projects, many of which became more active to take advantage of the stimulus.

Under Chinese regulations, local governments and municipalities can't borrow directly from banks or otherwise issue bonds to fund their infrastructure projects or the real estate speculation that some have conducted on the side. They can, however, set up investment vehicles called Urban Development Investment Corporations (UDICs) to raise funds on their behalf.

There are thousands of UDICs across China and most are highly leveraged. While most of the loans to UDICs are secured by property, others are unsecured -- backed only by guarantees issued by the municipal governments. The worry is that a large number of the loans to UDICs were directed to projects that may never be able to repay the underlying debt. Citibank analysts estimate 22% of the loans will turn sour by 2011. Victor Shih of Northwestern University estimates the total loans made to the UDICs between 2004 and 2009 at 11.4 trillion yuan, nearly twice the amount that has been reported by Chinese media. Mr. Shih reckons that ultimately one-quarter of these loans will go bad.

Theoretically, local governments could raise cash to cover these obligations by selling more land. However, if interest rates rise and the nation's property market crashes, this may not be possible and bad-loan levels could soar.

The authorities realize UDICs house potential bad-loan problems. In late 2009 the Ministry of Finance instructed municipal governments to stop providing guarantees for bank debt and announced plans to nullify all guarantees already provided. The China Banking Regulatory Commission has ordered banks to reassess all loans to UDICs and to cease additional funding if adequate security is not provided. Over the weekend, Chairman Liu Mingkang announced this review must be finished by June.

So, should foreign investors be getting excited? Unfortunately, not as excited as they were the last time. The banks may eventually be required to segregate the bad loans of the UDICs in a structure that might resemble one of the old asset-management entities. But due to their political significance it is not likely these will be offered for sale to foreign investors. They will instead be resolved internally by the government.

UDICs won't be the only borrowers producing bad loans following the great stimulus-prompted lending spree of 2009, and China's banks may well soon begin reporting nonperforming loans in greater numbers. This may cause more loans to be transferred to the AMCs, and it is these loans that may end up being the catalyst that marks the return of the bad-loan foreign investor to China. The scale of that return, however, is yet to be seen.