Chinese banks have a colossal mess of bad debts to clean up for the second time in as many decades, but they are unlikely to call in the financial world's most efficient mop and broom.
Foreign investors that specialize in buying up distressed debt are queuing outside the industry's door, but bankers say China's reluctance to pay the price of a privately funded clean-up means that door probably won't open -- to the cost of Chinese tax-payers and, ultimately perhaps, the wider economy.
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Some economists believe the current mess will need a bigger clean-up than was required after the late-1990s Asian financial crisis. From 1999 to 2007, about $323 billion in bad loans were swept out of the banks, according to a PriceWaterhouseCoopers (PwC) review of media reports over the period, in what amounted to a taxpayer-funded bailout.
"Sometimes the door is open for foreigners to come up and make money, and sometimes it's closed," said one veteran debt specialist who has bought and sold Chinese debt for global investment banks. He declined to be named due to the sensitivity of discussing China's sovereign debt.
"Our belief right now is that the door is closed."
There is no ban on foreign investors buying up bad loans, but veterans of the 1999-2007 clean-up say the environment is as hostile to outsiders now as it was back then. A decade ago, they played only a limited role due to time-consuming red tape and difficulties enforcing their rights as creditors, such as being able to seize assets pledged as collateral for a soured loan.
By 2006, according to PwC's own estimates, foreigners bought up $26.5 billion, or around 18 percent of bad loans sold by four state-backed vehicles that had been created to clean them up at the country's four biggest banks.
From 2002 to 2007, investment banks like Goldman Sachs, Morgan Stanley and UBS bought billions of dollars of bad loans from these four so-called asset management companies.
Goldman Sachs now believes China's credit losses, including among non-bank lenders, could reach up $3 trillion. Officially, non-performing loans (debts overdue by 90 days) stood at 539.5 billion yuan ($88.10 billion) or 0.96 percent of total bank loans at end-June, the seventh straight quarterly rise in bad debts.
Without deep-pocketed foreigners, the public purse will again pick up a large part of the final bill -- suggesting that the bailout this time could be another lengthy process which could keep the economy from rebounding as quickly as it might.
With bad debts gumming up the system, China's big banks could slow the pace of lending. That, in turn, could hold back the growth of small and medium sized companies, which are China's main economic engine and job-creator, and leave them struggling to finance expansion, or even daily operations.
China has shown few signs that it is thinking of opening the door to foreigners. In August, Reuters reported that it was developing a new loans-trading platform that could enable banks to sell loans to a wider range of investors, raising speculation that it could one day be used to trade bad loans. But it remains to be seen whether foreign buyers would be allowed to use it.
In the meantime, China's banks are reporting a steady rise in overdue loans. Some are coming to the stock market for more capital, with sixth-largest lender China Merchants Bank <600036.SS> raising 27.5 billion yuan from its Shanghai shareholders last week to meet new capital adequacy rules.
Mainland banks are expected to raise a total of at least 210 billion yuan in capital by 2015, but there is a widespread expectation that the taxpayer will stump up heavily as well.
China's big four banks -- Industrial and Commercial Bank of China <601398.SS>, China Construction Bank <601939.SS>, Agricultural Bank of China <601288.SS>, and Bank of Communications <601328.SS> -- remain well capitalized, but its slowing economy is raising broader worries.
Apart from concerns over some smaller banks, there are an estimated $5 trillion worth of loans sitting outside the formal banking system, putting stress on the financial system. No one has a clear idea of how heavy defaults in this shadow banking sector could rebound on the formal banking sector.
Such a climate would be normally a good one for foreign institutions specializing in buying up bad debts. Apart from the global investment banks, these include Apollo Global Management , Oaktree Capital Management, S.C. Lowy, Clearwater Capital, Pacific Harbor and Shoreline Capital, to name a few.
But in the case of China, either banks won't sell their debts at a price foreigners would consider reasonable or the foreigners are worried they will not be able to enforce their rights as creditor when it comes time to collect a bad debt.
Some of those who tried to get involved in the last clean-up were left jaded from tough court decisions and a bureaucratic system they say is tilted in favor of local buyers.
"Historically it took more than twice as long for foreign buyers to do a deal in China compared to other Asia markets, and the returns were less than half," said Ted Osborn, a Hong Kong-based partner at PwC and specialist in non-performing loans (NPLs).
Osborn said that in the heyday of NPL trading in Asia, in the early 2000s, deals that would get done in Thailand or Taiwan in up to six weeks would took as long as six months in China.
A government price-setting system that priced loans for foreign buyers too high was a major contributor to the low returns. The major obstacle, according to foreign bank sources, was the role of the courts in obstructing owners from seizing control of assets in the event of default.
A self-imposed 2007 policy by China's courts suspended filing of any new NPL-related cases pending Supreme Court guidance. Later Supreme Court rulings, including one against UBS which blocked access to collateral pledged by loan guarantors, effectively drained foreign appetite for China NPLs.
NOT OUT OF THE PICTURE
While international investment banks may be less equipped financially to buy up Chinese loans today than they were 10 years ago, they are not entirely out of the picture.
Western private equity firms, hedge funds and specialist debt funds are interested in China's distressed loans as well, according to investors and bankers.
But if history is any indication, a long wait may lie ahead.
Chinese bureaucrats running the auctions in the 2002-2007 era came under fire for selling the debt too cheaply to foreigners, according to people involved at the time.
"If you went to a meeting with Bank of China <601988.SS> today and mentioned NPLs, they would stare at you blankly and refer you to someone senior," one investor said. "No one wants to get asked why they sold to a foreigner."
(Additional reporting by Saikat Chatterjee; Reporting by Stephen Aldred; Editing by Michael Flaherty and Mark Bendeich)