China is attempting to align its insolvency regime to international standards and introduce additional tools for dealing with the country's rising debt load.
Australian lenders with exposures to these debts (particularly in the coal, steel, manufacturing, cement, shipbuilding, solar, heavy machinery, mining and property sectors) should reassess insolvency risk and understand their options.
For distressed asset managers, asset reconstruction companies and special situations investors, the opening up of China's distressed debt market may provide new investment opportunities.
Managing the debt
In 2015 the Chinese Government committed to reducing its "zombie" companies by 345 by 2020. Outside China this was met with scepticism given the country's history of supporting state-owned enterprises (SOEs) by ever-greening loans.
However, as debt within SOEs is now estimated at more than $US11 trillion and international institutions (including the Bank for International Settlements and the International Monetary Fund) continue to sound the alarm over China's rising debt levels, we are seeing attempts by the Chinese Government to provide the market with more sophisticated tools for dealing with unprofitable companies.
In a bid to help lenders write off RMB 1 trillion in NPLs in the next three years, Chinese authorities are:
- pressuring banks to clean up their balance sheets, particularly for small- to medium-sized companies;
- consenting to debt securitisation (six banks will be allowed to securitise about RMB 7.7 billion in NPLs and sell them to investors);
- encouraging credit default swap trading (two new financial instruments ‒ CDSs and CLNs ‒ have been introduced to allow investors to hedge exposures to individual issuers, rather than to specific obligations alone); and
- encouraging companies to reduce overcapacity, convert debt to equity and create access to equity through listings on China's stock exchange.
More than just talk…
On 12 September 2016 Guangxi Nonferrous Metals Group became China's first state-owned interbank bond issuer to be placed into liquidation with debts of over $US2 billion (RMB 14 billion), after defaulting on two private placement notes this year. While there have been 41 defaults in China's bond market this year (70% being SOEs), this is the first in the liquid domestic interbank bond market.
In another first, Sinosteel's debt-for-equity plan has been approved by the Chinese Government (China's last debt-for-equity swap program was run over 15 years ago in the late 1990s and early 2000s). The plan will see the State-owned Assets Supervision and Administration Commission (SASC) invest RMB 10 billion into the company, with around 80 Chinese and foreign lenders swapping around RMB 27 billion into three-year equity convertible bonds. The remaining debt will be repaid at an interest rate of about 3%.
China's second largest steelmaker, Baosteel Group is to merge with the heavily indebted, Wuhan Iron and Steel, to form Anben Steel. This consolidation is part of the Government's wider plan to cut excess capacity in the steel sector by 2020. These plans will also extend to the coal sector.
On 9 September 2016 the National Association of Financial Market Institutional Investors published sample clauses for bond covenants into the domestic market to cover a greater range of default scenarios (eg. cross-default clauses, change of control events and limits on certain risk events (eg. asset sale restrictions)). This is significant as the regulator is embracing international standards to improve investor protection from increasing onshore defaults. If the sample clauses are adopted, it may result in an uptick of defaults particularly for bond issuers that are highly leveraged.
For lenders ‒ The Guangxi Nonferrous liquidation will provide lessons for how China will resolve complex bankruptcies.
The role of SASC: Creditors have been disappointed with the handling of previous restructuring negotiations, blaming the failure of the company on the SASC. Guangxi Nonferrous had made an application to the Nanning Intermediate People's Court in December 2015. The Court gave ordered a grace period of six months for a committee to restructure the debt. Apparently, despite the committee reaching out to investors to bail out the company, creditors have alleged in a complaint to the National Association of Financial Market Institutional Investors (China's corporate bond regulator), that the committee did not properly inform the creditors of the proposed restructuring plans or follow market disclosure laws to inform the public of the same.
Low claim ratio for bondholders: Based on reported historical data of SOE liquidations, the return in the Guangxi Nonferrous liquidation is likely to be less than 20% (with some estimating the recovery rate to be lower than 10%). Until now, investors of defaulting SOEs have not experienced heavy principal losses on public bonds as issuers have managed to secure alternative funding to fully repay bondholders or been able to negotiate extensions in maturity dates (both of which appear unlikely for Guangxi Nonferrous).
Employee relations: Allowing companies to fail is a complex political challenge for the Chinese government. Workers have rarely had to deal with job loss through insolvency as, under China's "command economy", SOEs are expected to provide life-long employment, retirement pensions, healthcare and other social welfare benefits for workers (a view bolstered by the lack of social security provided by the government). For example, in the Guangxi Nonferrous liquidation, the Court will run a bankruptcy auction of the company's assets and use the funds to pay administrative expenses, employees, taxes and then creditors. Around RMB 16 million will need to be raised to pay employee entitlements, which are based on duration of employment and average salary for the previous year before liquidation. Despite the employees' priority position, employees are dissatisfied because the company reduced the average salary of its staff by nearly half at the beginning of 2016 ‒ thus affecting their payout figure. Similarly, in respect to the Anben consolidation, the parties are finding it difficult to execute the merger because of competing interests regarding costs, revenue sharing and job losses.
In respect to the use of debt-for-equity swaps, it will be interesting to see if China's program simply converts bad debt into bad equity. Time will tell as other issuers make use of these reorganisation tools. For example, the Liaoning Government has filed for a court-ordered restructure of Dongbei Special Steel after it failed to make payment on bonds of about RMB 4 billion and creditors rejected an initial debt-for-equity swap. Similarly, the Bohai Steel Group, which owes RMB 192 billion to 105 creditors, is also looking to convert debt into bonds as part of a restructure.
For bondholders ‒ Expectations of further losses for bondholders may disrupt China's corporate bond market, deterring some foreign investors and increasing risk premiums as more defaults and liquidations are permitted. However it is likely that mixed signals will continue from Chinese authorities, as some companies will be allowed to fail, while others will be restructured through debt-for-equity swaps or given bailouts. The continued steps to devalue the RMB will place greater stress on bond issuers who have accessed offshore capital markets.
For distressed asset managers ‒ NPLs have grown over the last five years, as the Chinese economy (dependent on monetary and fiscal stimulus) has seen a rapid rise in debt and a slowdown in its economy (mainly due to overcapacity and declining demand). Chinese companies who borrowed heavily are now facing difficulties repaying their debt.
The opening Chinese NPL market may generate opportunities for high returns, however it's unclear how much of an opportunity it will become.
On the one hand, these assets are attractive because offshore firms are able to invest directly (often with a local asset management partner ) and end up as a primary lender. For example, KKR and the state-owned China Orient Asset Management co-invested in credit and distressed Chinese property opportunities. PAG has also reportedly started a distressed fund in China to acquire NPLs.
However, on the other hand, investors need to be able to navigate local regulations (including foreign investment provisions and stock exchange guidelines) and have sound relationships in the domestic market (preferably with recent restructuring experience) to be presented with and be able to identify quality investment opportunities. Previous experience in the 1990s and 2000s has shown that Chinese NPL market is tough for foreign investors, as many quality NPLs are likely to go to domestic investors (there being a concern about providing foreigners with the opportunity to make large returns by buying state-owned assets at a discount) and a lack of appetite to resolve NPLs on a commercial basis (usually to prevent the crystallisation of losses).
However if NPLs continue to increase and the need to offload NPLs becomes more imperative, quality opportunities may present themselves more readily to foreign investors.