Spectrum – December 2015 Business Recovery Services

China’s Non-Performing Loans are rising fast Are there now opportunitiesfor investors?

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This year, China’s economic narrative has focused on the ‘new normal’ of slowing economic growth and a gyrating stock market. The unexpected decision by the People’s Bank of China (PBOC), China’s central bank, to devalue the Renminbi (RMB) to its lowest rate in three years against the US dollar was widely seen as a signal that Beijing was trying to shore up the nation’s economy, which is now growing at below 7%, the slowest pace since the immediate aftermath of the 2008 global financial crisis. The PBOC’s action sparked turmoil in markets globally and was possibly one reason why the US Federal Reserve did not follow through with a long-predicted September 2015 interest rate hike.

But currency devaluation and stock market correction aside, scrutiny and speculation on the asset quality of China’s financial sector has been growing for some time, as has the level of NPLs.

In this issue of Spectrum, we take a look at China’s latest NPL statistics, explore the reasons behind the recent increases in NPL levels at the nation’s banks and give our view on what this means for potential NPL investors.

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What is the current NPL situation in China?

NPLs in China are clearly on the rise. Data from the China Banking Regulatory Commission (CBRC) indicates that both the level of NPLs and the NPL ratio (defined as total NPLs over total loans) of the country’s commercial banking sector have increased steadily over 16 consecutive

quarters, reaching RMB 1,186 billion and 1.59% respectively, at the end of September 2015 (see chart below). In the first nine months of 2015 alone, the rise in the reported NPL balance (RMB 343 billion) was greater than the total rise during 2014 (RMB 251 billion). Long gone are the days where banks could manage their NPL ratios at around 1% or below.

Why is this happening?

In a nutshell, rising NPLs in China’s banks are the direct result of an unprecedented 5 year debt binge and a slowing economy. As the effects of the 2009 stimulus package wear off, industrial over-capacity together with higher leverage and slower economic growth and demand means many Chinese companies are seeing their cash flows suffer and are finding it tough to repay their debts, causing NPLs to rise rapidly.

(1) RMB 4 trillion financial stimulus package in 2009. Following the global financial crisis, a government led loose credit environment coupled with a state-directed RMB 4 trillion financial stimulus package gave a tremendous boost to the economy. Chinese debts rose rapidly, fuelled by real estate lending and shadow

banking activity. By June 2014, China’s debt to GDP ratio reached 282%. Whilst this seems manageable for now, it is higher than many developed nations such as Australia, the US and Germany (274%, 269% and 258% respectively). This increased leverage places additional pressure on China’s corporate sector to continue growing cash flows to service debt repayments.

(2) China is facing industrial over-capacity in many sectors. The boom in investment has led to over-capacity in many capital intensive sectors, including the steel, cement, solar, shipbuilding, heavy machinery and mining industries. Many NPLs have been concentrated in lending to these sectors as demand has dropped and banks have stopped automatically rolling over loans.

(3) Slowdown in China’s economy.It’s no secret that China is now entering a slower growth phase as its economy matures. In 2014, China’s annual GDP growth rate was 7.4%, slightly shy of its target of 7.5% and the lowest for the last 14 years (see chart on following page). China aims to achieve an annual GDP growth rate of around 7% in 2015 and the recent stimulus measures (including interest rate and reserve ratio cuts to shore up growth) are likely to delay Beijing’s aim to reduce the pace of increased financial leveraging.

NPL balance and NPL ratio in Chinese commercial banks (in RMB billion)

Source: CBRC’s statistical reports

Year

1,200

1,000

800

600

400

200

-

1.60%

1.40%

1.20%

0.80%

0.40%

0.20%

0.00%

1.00%

0.60%

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q42010 2011 2012 2013 2014 2015

NPL balance NPL ratio

Q1 Q2 Q3

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Source: The World Bank

China GDP Growth (annual %)

Annual %

14.0

12.0

10.0

8.0

6.0

4.0

-

2.0

16.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Year

7.78.4 8.39.1

10.0 10.111.4

12.714.2

9.69.2

10.69.5

7.8 7.4

How does China’s NPL ratio compare with other countries?

China’s stated NPL ratio of 1.59% is towards the lower end of global levels (see chart below). However, this is due to both the differences in the way that China and the rest of the world classify loans as NPLs and their relative positions in the credit cycle.

China has its own unique way to recognise NPLs. Take the situation where a company (let’s call it “Shenzhen Trade Company Limited”) is in trouble. Due to the fall in global commodity prices, its orders are down, its cash reserves are low and it is now more than 90 days past due on a scheduled repayment of a RMB 100 million loan with its bank. But its bank took a legal charge over Shenzhen’s head office as security, and because the market value of this prime real estate is much greater than the loan, the bank is very confident that it will not suffer a loss.

In most of the rest of the world, because the debt is more than 90 days past due, banks would generally acknowledge the exposure to

Shenzhen as a NPL. But as Shenzhen’s bankers do not expect a loss (given the expected net proceeds from any sale of the head office would fully cover the loan amount), they would not make any specific provision against the loan and it would not be classified as an NPL.

Unlike western banks, when assessing whether a loan is an NPL, Chinese banks are allowed to consider whether they expect to suffer a loss should a company default. So given there is no loss expected, the Shenzhen exposure is unlikely to be recognised as an NPL, despite it showing obvious signs of stress.

Summary of differences in NPL and provisioning rules:

Western banking “norm” China

NPL when: • Loans are more than 90 days past due

• Loans are less than 90 days past due but there are other warning signs

• Loss given default is not a factor in the assessment

• The borrower cannot repay the loan and (even after considering the collateral value) there may be a loss

• Loans more than 3 months past due are ‘usually’ an NPL only when the bank expects a loss

Minimum provision on NPL:

• No minimum

• Provision based on bank’s best guess of the expected loss given a default

• Provisions at the portfolio level must be at least 150% of the aggregate NPL balance and at least 2.5% of the total loan book

Source: CBRC provisioning rules

China’s NPL ratio remains low in an international context (data at 31 December 2014)

Source: The World Bank

0% 1% 2% 3% 4% 5% 6% 7% 8% 9%

Canada

South Korea

Australia

Malaysia

Japan

US

Philippines

Indonesia

Thailand

UK

Brazil

South Africa

India

Russia

Eurozone

China

World Bank global

average: 4.2%

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Are China’s NPL levels understated?

The reported NPL ratio at China’s banks is 1.59% using the CBRC rules. But is it an accurate reflection of the “true” level of NPLs at China’s banks when western banking norms are applied? Given the state of the economy and the government pressure on banks to manage their stated NPL ratios, this is a good question to ask.

“It would be normal for the NPL ratio to reach 2% – 3% given we are entering the ‘new normal’ phase of the economy” - Big 5 Bank CRO, January 2015

Although it is unlikely that the Chinese bank would classify Shenzhen’s loan as an NPL, it would probably classify the exposure in a category called “Special Mention” (banker code for “loans we need to keep a close eye on and do what we can to make sure they don’t turn into a NPL”). Other types of lending in this category are loans that are between 1 and 90 days past due (although to complicate matters further, loans between 1 and 90 days past due may in some instances be classified as NPLs).

Although not all loans in the Special Mention bucket will become NPLs in the future, the volume of this category of loans in China is both significant and growing (see chart). So all things considered, should western banking “norms” be applied, 3% - 5% is probably a more realistic level of the NPLs in China’s banking sector today1.

How will China’s NPL situation develop?

We see it as being inevitable that NPLs in China’s banking sector will continue to rise to levels unprecedented since banking reform measures were undertaken 15 years ago. How high they will go is anyone’s guess as Beijing has the ability to control the speed of loan defaults as a significant portion of the lending in the system is done by state-owned banks and companies. We therefore see the risk of a financial crisis emerging in the banking sector as being extremely low.

However, the unfortunate side-effect of government intervention into the NPL situation is that the financial system is not currently resolving the underlying NPLs-many are not being worked out on a commercial basis. This means that a change will be required to create a sustainable long term solution.

Over the next 12 to 18 months, we expect China’s banks will continue to report a rise in NPL levels. However, the rate of the rise will be impacted by:

• The extent to which banks will continue to embrace an ‘extend and pretend’ philosophy, particularly in relation to loans to state owned enterprises (SOEs) and local governments;

• The rate at which banks resolve NPLs or sell NPLs to either Big 4 national or local Asset Management Companies (AMCs)2 or other parts of the financial system (the NPL ratio relates to the banking sector only, so sales to AMCs, related parties, Trusts etc. reduce the reported numbers);

• Further monetary (and regulatory) stimulus to alleviate the debt repayment pressures on corporates and individuals;

• Beijing or provincial government financial support that can be directed towards distressed SOEs and local governments;

• The natural dilution of the NPL ratio, caused by the growth in the total loans year-on-year (we expect the relaxation of the loan deposits ratio to boost loan growth)3; and

• The state of the economy.

NPLs and Special Mention loans are growing

Source: CBRC data, PwC analysis

December 14 September 15

2.1 trn

3.12%0.8 trn

1.25%

2.8 trn

3.77%1.2 trn

1.59%

NPLs Special Mention

RMB trillions (% of total loans)

1. While this may be a more realistic level of NPLs we think the CBRC is highly unlikely to make a u-turn and modify the current accounting rules to force Chinese banks to recognise NPL levels in this range given Beijing’s desire for the banking sector to work out its NPL problem in a gradual and stable way.

2. A detailed list of the AMCs currently operating in China is provided in the back of this report.

3. Unlike its success in the early 2000s, we do not think China can today grow itself out of its NPL problem. In the early 2000s, China’s GDP was relatively low compared to today as was its total lending book. But after several years of double-digit GDP and even bigger loan growth China’s banks were able to grow out of their NPL problem as the cumulative level of new lending began to dwarf the level of NPLs (despite legacy NPLs on their books fewer new NPLs from new lending were being generated due to the robust economy). Today, with total loans of RMB 73 trn - roughly the same size at that of the US – China will be hard pressed to do this. First, natural growth is not there—the

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How big a factor will real estate be in all of this?

Much of the press around Chinese banks’ asset quality focusses on the inherent relationship between the real estate market and NPL levels. Whilst this is true, the same can arguably be said for any banking system.

Admittedly, the impact of real estate on the level of China’s NPLs could be dramatic. China Orient AMC’s 2014 NPL Market Research Report estimates that if property prices fall by 30%, it will exceed the banks’ capacity to cope with losses. Commercial property prices in 2nd tier cities and industrial property prices have already adjusted downwards by more than 30% since 2013, although the impact on banks’ balance sheets is highly dependent on the loan-to-value at which individual loans were underwritten at.

The risk of further falls cannot be ignored, although recent monthly data indicates prices may be bottoming out. Overall, although there remains oversupply in lower tier cities, we believe the risk of a material downturn in China’s real estate market remains low given government support for this sector (which we expect to continue).

Whilst there may not be a looming meltdown in the real estate sector, bank earnings are often negatively impacted if they decide to foreclose on real estate held as security. This is because at auction they may not be able to get anywhere near the amount stated in the ‘market’ valuation used to support their accounting provision. So an industrial property valued at RMB 100 million when provisions were recognised may only fetch RMB 50 million at auction, and the bank will have to make an additional write down of RMB 50 million. NPL buyers factor this into their

analysis when arriving at bidding prices so taking a hit on earnings is inevitable for banks whether they work the loan out themselves or sell it on to investors.

“Global banks have been shedding assets and are willing to service transaction opportunities. Chinese banks have not realised this yet, but they eventually will. There is political pressure - they act like a herd.” - Foreign Bank, Head of Special Asset Management, November 2015

Can foreign investors expect a vibrant market in China to acquire NPLs?

The short answer: Not right now, but maybe in 1-2 years. We explain below:

Banks are under tremendous pressure to deal with their NPLs. In an effort to maintain international and domestic confidence in China, its commercial banks are under a huge amount of pressure by the government to manage their NPLs. Rising NPL levels reduce profitability and constrain capital (as provisions erode a bank’s equity). Competing pressures to show continued growth in profitability means that banks need to find solutions to offload NPLs without crystallising losses. This is not easy.

NPL sales are the fastest way for banks to offload problematic loans from their books but right now they are not selling as many NPLs to the AMCs as they would like due to the additional losses they would have to recognise on sale. Currently, Chinese banks are allowed to bulk-sell NPLs to the Big 4 AMCs or the local AMCs. Given their larger capital bases and levels of liquidity, the Big 4 AMCs are the more active buyers right now but at present banks are having difficulty selling their NPLs to the AMCs at acceptable prices. This is because unlike 15 years ago, the AMCs are today only buying NPLs on a

commercial basis (meaning a price lower than what the bank’s carry the portfolio on their books for).

For example, if the Shenzhen loan was not secured by prime real estate but instead by an unused factory in a Tier 3 city valued at RMB 40 million, the bank would need to recognise the debt as an NPL. The debt would be written down and (given the bank doesn’t have the patience or capital to wait for the repossession process to work its way through the courts) packaged into a NPL portfolio, requiring a loan loss provision of 60%4).

AMCs bidding on the loan will factor in the lower value that will be obtained on the foreclosure of the factory in their bid and only offer to buy the loan at around 20% of face value (RMB 20 million) as they need to make a profit. This means Shenzhen’s bankers, should they decide to sell the loan, would need to crystallise a further 20% loss on the sale.

Given the level of general provisioning that has already been recognised by Shenzhen’s bankers (i.e. at least 150% of NPLs), they may be capable of absorbing a loss of this size. However, they may be loath to do this if their capital levels are sufficient to allow them to continue to grow lending. Instead they may prefer to hold onto the NPL in the hope that the value of the factory increases in the future.

As AMCs are also looking to maximise their profits, many planned NPL portfolio sales by banks are unsuccessful (anecdotal evidence suggests more than one half of planned sales fail due to the parties being unable to agree a price).

economy is slowing. Second, even if Beijing ordered the nation’s banks to keep on lending, more and more of this new lending would be to companies already having difficulty repaying their loans and this would only serve to exacerbate the problem.

4 60% is the difference between the loan of RMB 100m and the expected proceeds from the sale of the factory of RMB 40m. The difference between the 60% provision for this specific NPL and the mandatory minimum provision of 150%, would be held as a general reserve against the banks performing loans.

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The outlook for foreign investors is uncertain in the short term.Most foreign investors exited the market during the first NPL cycle (2001 – 2008). There were many reasons for this, including a lack of steady supply and a general view that foreign owners of domestic debt could not get a fair shake in local courts. We are aware that many foreign investors are now investigating the China NPL market and are excited about its prospects. So is the timing right to re-enter?

At this point we believe the AMCs won’t likely be showing foreign investors their quality NPL portfolios. Why? Foreign investors are the last buyers the AMCs want to sell to. The AMCs face huge political risk if they sell portfolios which subsequently generate large returns to foreign investors (as they would be perceived to be giving away state owned assets on the cheap). Today, for loans they don’t keep for themselves to work out, the AMCs preferred buyers are government related entities such as provincial AMCs and local governments. They can still make profits on such sales whilst being seen as keeping the loans “in the family”. Remaining NPLs earmarked for third party buyers tend to be sold to domestic parties, often small cartels of local businessmen with connections at the AMCs. These domestic investors can get sweetheart deals foreigners can only dream of.

But foreign investors should not necessarily stay away. Although good opportunities may be scarce in the short term and there is a significant risk of getting burnt, banks are coming to us with 5-10 credit portfolios they are looking to sell. If foreign investors can acquire such a portfolio at a good price (not easy!) it will provide them with a good learning ground and prepare them for bigger and better opportunities in the future. Another option for foreign investors at this point in the cycle is to attempt to establish a joint venture with an AMC to acquire and resolve NPLs together. AMCs are always looking for capital to acquire portfolios and are receptive to such arrangements. When the market does properly reopen, foreign investors that have credible relationships in the market together

with recent transaction and work-out experience will be in a far better position to identify and close on better quality portfolios.

But let us be clear. While foreign investors will certainly be able to participate in the market when NPL sales begin to take off, we expect the bulk of the portfolios will be sold to domestic buyers. Unlike 15 years ago, domestic buyers now have the capital to invest and unlike foreign buyers, they have a better idea of what they are getting into. They are also less concerned with required IRRs and this helps in pricing discussions. In addition, domestic buyers have fewer due diligence and structuring demands, making them much easier to deal with than foreign investors. Finally, sales to domestic buyers require fewer approvals. Given these factors, we believe that unlike the first NPL cycle, domestic buyers will dominate the next cycle when it really starts to take off.

In the medium term, we expect the outlook for foreign investors to improve. We expect over the next 12-18 months banks will need to free up capital for new lending and will have no choice but to sell more and more NPLs to the AMCs, greatly swelling their inventory.

As the volume of NPL stock in the AMCs increases, they will be under increasing pressure to find quick solutions (given delays in working out NPLs are a drag on returns) and this will lead to increased sales. Whilst the AMCs will continue to sell much of their stock to government related

buyers, there will be sufficient overflow that will lead them to revert to the old days (2001-2008) when they carried out traditional auctions, inviting both foreign and domestic bidders. And while concerns about selling to foreign investors will still persist, the sheer supply and the AMCs’ need to offload their inventory should give foreign investors a much better opportunity to enter the China NPL market than at present.

How can we assist NPL investors?

When it comes to NPL issues, PwC’s Portfolio Advisory Group has the necessary experience to help you navigate through the loan acquisition and recovery process. Our people have been working on NPL assignments in China since 2001, advising on the sale or acquisition of over 40 NPL portfolios and the setup of the relevant investment structures. The depth and breadth of our experience gives us unique insights into the loan valuation and recovery process that can really help when it comes to portfolio or single credit evaluations and pricing discussions.

Our team provides help to both buyers and sellers of NPLs. We can manage and/or narrow the expectation gap between NPL sellers and buyers to make the deal process seamless. We can also introduce you to our contacts in the banking/AMC sector and help you to perform due diligence on (and give you a view on the value of) the underlying credits and advise you on recovery strategies to maximise your investment.

ContactsTo hear more please contact any one of our China NPL specialists:

Ted OsbornPartner +852 2289 2299t.osborn@hk.pwc.com

Christopher SoPartner+852 2289 2577christopher.mc.so@hk.pwc.com

Victor JongPartner+86 (21) 2323 3650victor.yk.jong@cn.pwc.com

James DilleySenior Manager+852 2289 2497james.ha.dilley@hk.pwc.com

Appendix 1: AMCs operating in China

Big 4 AMCs:

Name Province

China Orient AMC National

China Huarong AMC National

China Great Wall AMC National

China Cinda AMC National

Local AMCs: Approved by the CBRC (to buy assets directly from banks)

Name Province

Anhui Guohou AMC Anhui

Jiangsu Provincial AMC Jiangsu

Zheshang AMC Zhejiang

Shanghai State-Owned Assets Operation Co Shanghai

Yuecai AMC Guangdong

Beijing Guotong AMC Beijing

Chongqing Yufu AMC Chongqing

Liaoning State-Owned Assets Operation Liaoning

Tianjin Jinrong Investment Service Company Tianjin

Fujian Mintou AMC Fujian

Shandong AMC Shandong

Hubei AMC Hubei

Ningxia Shunyi AMC Ningxia

Jilin AMC Jilin

Guangxi Jinkong AMC Guangxi

In operation, but not approved by the CBRC: (meaning they can only buy assets from other AMCs)

Name Province

Liaoning Lianhe AMC Liaoning

Shanxi Nongxin Assets Investing Holding Group Co Shanxi

Shandong Guotou AMC Shandong

Henan Small and Medium Enterprises AMC Henan

Anhui State-Owned Assets Operation Co Anhui

Anhui High Technology Industry Investment Co Anhui

Zhejiang Provincial Development Asset Operation Co Zhejiang

Sichuan Furun Corporate Restructuring Investment Co Sichuan

Shaanxi State-owned Assets Management Co Shaanxi

Jiangxi Provincial State-owned Enterprise Assets Operation (Holdings) Jiangxi

Guangxi Guowei AMC Guangxi

Tibet State-Owned AMC Tibet

Xinjiang Xinye Assets Operation Co Xinjiang

Hainan Union AMC Hainan

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