The Perils Of Red Capitalism

Beijing learned a costly lesson from the collapse of two investment trusts

Larry Yung was the shrewd operator, amassing a multibillion-dollar portfolio in Hong Kong blue chips and hobnobbing with the money elites of Asia and Europe. Huang Yantian lived more on the edge, a former party official turned wheeler-dealer who cruised the streets of Guangzhou in a silver Lexus and knew how to get around Beijing's dictates. As the guiding lights behind two of China's most entrepreneurial financial institutions, Yung and Huang presented different faces of red capitalism. But both were golden in the eyes of Western banks and investment houses that threw money at their firms--CITIC Pacific Ltd. and Guangdong International Trust & Investment Corp. (GITIC), respectively--during China's go-go years.

No longer. As details emerge of the financial missteps at Yung's CITIC Pacific and Huang's GITIC, it's becoming clearer both fell victim to the same delusion: that global capital markets would continue to supply cheap money without asking hard questions. With the Asia crisis gouging earnings at CITIC Pacific, investors are jumping ship, sending the stock down by 70% from its 1997 peak. That's bad news for the firm's powerful parent, Beijing's China International Trust & Investment Corp. (CITIC), which derives nearly all its profits from the Hong Kong subsidiary. A controversial bailout from Beijing earlier this year saved Yung from financial ruin. Now, CITIC is getting $4.5 billion in help from China's Finance Ministry.

GOOD INTENTIONS. Huang wasn't so lucky. On Oct. 6, Beijing authorities, alarmed at GITIC's staggering foreign debts and reckless management, shut the firm down. Now listed as a GITIC consultant, Huang hasn't been seen in public for months and is under investigation, according to government sources. He could not be reached for comment and apparently has not been charged with wrongdoing.

The travails of Yung and Huang highlight the newest peril to China's economic health. CITIC and GITIC are but two of hundreds of firms, known as trust and investment corporations, set up with the blessings of the late Deng Xiaoping in the 1980s to help central and provincial governments raise foreign funds and invest in strategic projects. But as wealth and a taste for risk-taking grew, these firms made billions in bad bets on dubious real estate projects and stock plays. By some estimates, half their $55 billion in assets are nonperforming. Though investment trusts make up a tiny portion of China's financial system, they've run up big, unhedged, short-term foreign currency debt from offshore lenders and bond investors. They've also been among the heaviest borrowers from China's four domestic banks. "If the investment trusts go down, then the banks are in trouble," says China finance expert Nicholas R. Lardy of the Brookings Institution.

Now, foreign bankers and rating agencies are wondering where the crackdown will lead and what it means for the financial sector. Unlike China's big state-owned domestic banks, investment trusts such as GITIC relied on foreign-currency loans for some 70% of their borrowing, according to Moody's Investors Service. And Beijing may not back all of them. Until the onset of the Asia crisis in mid-'97, it was easy for them to raise funds from foreign banks and investors eager for a piece of China's booming economy. Since then, foreign interest has dried up.

NO GUARANTEES. At the same time, Beijing bureaucrats who thought they were safe from the Asian contagion are learning that China's exposure to foreign borrowing is greater than they thought. What's more, many funds borrowed by investment trusts in Guangzhou, Shanghai, and other cities have been plowed into risky investments such as office towers and condominiums. Many local governments who control the trusts are in no position to bail them out if bets go sour, according to a study by Moody's.

By shutting down GITIC, Premier Zhu Rongji is sending a message to local officials and foreign bankers alike: No one is so powerful that his survival is guaranteed. In 1997, authorities shut down the China Agribusiness Development Trust & Investment Corp., which had engaged in massive property speculation in Hainan Province. Earlier this year, Beijing shuttered China Venturetech Investment Corp., one of the country's first venture-capital firms, and Hainan Development Bank--the first time a deposit-taking state bank was closed.

To many observers, the crackdown is encouraging news. Unlike other Asian countries snarled in the crisis, China is starting to discipline profligate financial institutions before it is too late. "This shows that China's economic system is coming of age," says Hong Kong Financial Secretary Donald Tsang. The crackdown also fits in with Zhu's desire to rein in unruly provincial leaders.

In GITIC's case, the beginning of the end came when Zhu's right-hand man, Wang Qishan, assumed the No.2 slot in Guangdong's government early this year. A rising star, Wang earned high marks as head of the China Construction Bank. Wang took one look at GITIC and reported to Zhu that it was "really badly managed," says one knowledgeable source.

OVEREXPOSED. Small cities throughout the province carried tremendous debt, Wang found, and some were linked to GITIC. Subsequent investigation revealed the full extent of GITIC's predicament. It had about $3.6 billion in debt, about $1.6 billion of it in foreign currencies. The bulk were short-term loans, even though they were used to finance long-term projects. GITIC's Hong Kong units owed a further $850 million. Plus, GITIC had guaranteed $1.8 billion--almost five times its capital--for other Chinese firms.

When cash-strapped Japa-nese and Korean banks began recalling their credit lines, Guangdongraised $1.7 billion to rescue GITIC, according to a Beijing newsletter linked to the Public Security Ministry. But Zhu decided in October to shutter GITIC and put the firm under the management of the Bank of China.

Huang also finds himself in dire straits, sources say. For 14 years, he was a driving force behind GITIC's move to become a local financial power. A politician and dealmaker rolled into one, he was a favorite of Western lenders and investment banks. But Huang angered Beijing. In 1997, he was behind the listing of GITIC Enterprises, whose stock offering was oversubscribed by 900times--the most enthusiastic response ever for an initial Hong Kong offering--and was even the subject of a May 6, 1994, BUSINESS WEEK cover story. Trouble was, banking sources in Hong Kong say, Huang didn't secure proper approvals from the central bank, which at one time tried to stop the listing. Beijing officials also were livid when GITIC raised $100 million in August, 1997, from Union Bank of Switzerland's branch in the Malaysian tax haven of Labuan--again, without approval. UBS declined comment.

Perhaps more surprising than the blowup in Guangdong, however, are the troubles at the biggest red-capitalist creation of them all--CITIC. Aside from Hong Kong's CITIC Pacific, the sprawling Beijing conglomerate is an ill-focused collection of weak companies that span banking, energy, communications, mining, advertising, and property. Like big groups in Japan and Korea, CITIC seems more concerned with size than profit. Last year, almost all of its $1.4 billion in earnings on $26.7 billion in assets came from CITIC Pacific or sales of the Hong Kong unit's shares.

Beijing wants to clip CITIC's wings too. Although it is in little danger of folding, supervision is shifting from the State Council--China's cabinet--to the central bank, which analysts say will exercise firmer oversight.

Just a few years ago, CITIC Pacific was the jewel in the crown of China Inc. Yung was the man to see for Hong Kong companies that wanted to cozy up to the mainland. The scion of an old Shanghai business family and son of China's recently retired Vice-President Rong Yiren, Yung had the pedigree to put both communists and capitalists at ease. During the past decade, he turned his tiny Hong Kong shell company into a multibillion-dollar empire with big stakes in Cathay Pacific Airways, China Light & Power, a tunnel company, and Hong Kong's huge Discovery Bay residential complex.

He also had expensive tastes. In 1993, Yung paid about $8 million for a 280-hectare estate in Sussex, England, once owned by former British Premier Harold Macmillan. A steward of the Hong Kong Jockey Club, Yung once won $5 million at the track--and pledged it to Stanford University, where his daughter studied.

Yung was as adept at using Hong Kong's capital markets as he was at using his connections, raising funds time and again through equity and bond offerings. Investors liked that, unlike his compatriots, he bought into sound companies rather than plunging into dodgy asset plays or playing the guanxi--connections--game. CITIC Pacific hired top professional managers, including a Briton and an American.

But something went badly amiss. CITIC Pacific's stock has fallen more steeply than the rest of the Hong Kong market. Yung has taken a beating as well. In early 1997, he bought a 15% stake in the company. At the time, it was a terrific deal: The shares were bought at a $475 million discount to the market price. Yung borrowed the money for the purchase, and analysts suspect he used the shares as collateral. But when CITIC Pacific's stock started diving, rumors swept Hong Kong that banks holding Yung's shares were ready to dump them. That sent CITIC Pacific stock down even further. Before long, Yung's sweetheart deal turned into a $1 billion paper loss--and Wang Jun, CITIC's chairman in Beijing, stepped in with financial aid.

As the glow from the China magic fades, analysts have stopped betting on hype and started looking at CITIC Pacific's business basics. They aren't great. Earnings fell 71% in the first half of 1998, and a quick turnaround is unlikely. Clarion Securities Asia Ltd. figures CITIC Pacific's cash flow will be insufficient to service its $3.5 billion in debt by next year. Traffic at Cathay Pacific has plunged, and it will post its first-ever loss this year. CITIC Pacific also is stuck paying high debt-service costs for its $2.1 billion purchase of a 20% stake last year in China Light, Hong Kong's electric utility.

The slowdown in Hong Kong's economy and stock market is hurting. CITIC Pacific has relied on healthy cash flow and new stock issues to pay off debts. But "this is not a good time to draw on capital from the Hong Kong markets," says Julia Turner, managing director for corporate rating at Moody's Asia Pacific Ltd. "It seems likely they will be unable to pursue their normal pattern."

The failure of its premier red chip would be enormously embarrassing for Beijing. That's why it's bailing Yung out. CITIC's Wang says he is providing the Hong Kong unit with $300 million. "If they go bankrupt, it would have a major impact on the entire Hong Kong stock market," Wang says. The parent is asking Hong Kong regulators to let it buy back its shares. It probably will pay less than half what it sold them for in 1997.

Beijing's intervention raises another concern about the investment trusts: their lack of transparency. Even though CITIC Pacific is listed in Hong Kong, numerous questions remain about Yung's share purchase and his bailout, even though the deals had a huge impact on the company's operations and share price. Yung has declined BUSINESS WEEK's interview requests for more than a year.

MYSTERY LOANS. Investors are getting fed up. CITIC Pacific now trades at less than two-thirds the value of the underlying assets in its portfolio. "The group is currently being valued as though it was going bankrupt," says Salomon Smith Barney analyst Anil Daswani.

Yung's operation is not the only headache for the parent company. Take its investment in Hong Kong's CITIC Ka Wah Bank Ltd. Jin Deqin, the bank's former chairman, is under investigation for a questionable $1 million loan to his son. Wang says that Jin also is being investigated in a graft case involving suspected misuse of bank funds. Jin was arrested last April and could not be reached for comment.

According to Wang, Jin was expert at playing one side against the other. When pressed for information by CITIC, Wang claims, Jin would say he was answerable to the Hong Kong Monetary Authority. And, says Wang, Jin would tell the Hong Kong authorities "that Ka Wah had a mainland background." Wang adds: "When we wanted to remove him from his post, we were under a lot of pressure, and it took us a very long time to solve this problem." Hong Kong officials insist they were not lax in regulating Ka Wah and did not give Jin any special treatment. Jin couldn't be reached for comment.

If China's brightest stars can get into such trouble, it's fair to expect more bad news. Shanghai's big trust company is heavily exposed to the property market in Pudong, the massive government-backed development east of the city. Vacancy rates in parts of Pudong are 70%. Investment trusts for the municipal governments of Tianjin and Shenzhen, as well as the provinces of Fujian and Shandong, also are carrying big debts. But Beijing is making inroads in reducing the number of such vehicles. At their peak, the country boasted more than 700 trusts. Now, there are less than 250. Hoong Yik Luen, head of China research at ING Baring Ltd., predicts "eventually they will be closed, one by one."

If that's the case, the face of China's financial system could change dramatically. By reducing fast-footed dealmaking at the local level, regional politicians will have a harder time finding funds to skim off or to funnel into pet projects. Beijing could also more easily clean out the rot and ensure lending follows globally accepted practices.

But there are big risks. If companies assumed to have the backing of provincial authorities--if not central ones--go under, foreign investors will be forced to reassess the creditworthiness of all Chinese borrowers. It would be harder for prosperous coastal provinces to attract foreign financing. And while the Bank of China may back GITIC's debt, it probably cannot afford to cover all the obligations of investment trusts. The fallout of a wave of bankruptcies would be messy and ugly, and could badly shake confidence in China's financial system. For China's freewheeling red capitalists, the end of an era is at hand.

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