Guangdong's Nasty Haircut

But behind the $6 billion workout, a hint of reform

The giant chandelier sparkled above. But below, the mood was as dark as the suits worn by the 500 bankers who crowded into the ballroom of the Grand Hyatt Hong Kong. Like fidgety children at a barber shop, they were waiting to learn how much of a haircut they would have to take on loans to Guangdong Enterprises Group, one of China's biggest corporate busts.

It was quite a scalping. Goldman, Sachs & Co., the company's adviser, explained that the banks would get their money back in the form of notes that would pay as little as 1% annually--and can't be redeemed for 10 years. In real terms, the banks will recover around 60 cents on the dollar. It is "a long way" from what lenders expected, grumbled a European banker at the meeting. Many thought their loans were guaranteed by the government.

Bankers may be miffed, but the $6 billion debt workout of Guangdong Enterprises Holdings and its affiliates could be a watershed for reform in China. Despite lack of information on the state of the underlying businesses, it is still the most fully explained restructuring of a state-owned holding company in China to date. And the Chinese government is chipping in assets to help fill the hole. With luck, the group will emerge debt-free.

SALES JOB. To shore up the group's assets, the provincial government would transfer one of its most lucrative units, Guangzhou Dongshen Water Supply, to the group's Guangdong Investment subsidiary. Goldman figures Dongshen is worth at least $2 billion. Guangdong Investment, which is listed in Hong Kong, will sell off noncore assets, such as property and infrastructure projects, to raise cash.

This is a much better deal than bankers got when Guangdong International Trust & Investment Corp. (GITIC) capsized in October, 1998. At first, the government assured foreign bankers that they would be repaid. But Beijing prevented the province from bailing out GITIC. Then, in January, the government suddenly declared GITIC bankrupt and said foreign creditors would get no special treatment. Lenders still don't know if they'll get anything back. "There has been no disclosure," fumes one GITIC lender. "It's absolutely amazing."

By handling the Guangdong Enterprises cleanup more professionally, Beijing hopes to repair China's credit in the financial markets. But it has a sales job ahead. The creditors' steering committee called the restructuring plan a "starting point" but "not satisfactory." Says a U.S. banker in Hong Kong: "Beijing may feel it's living up to its commitments, but I don't think any bank will accept that claim." Banks still want China to pay off all debts in full and on schedule, saying that the Guangdong government had promised to back them up. They also claim to have documents to prove it. "The Chinese unquestionably have the resources, but not the willingness, to meet the obligations," contends one creditor.

With the economy slowing and financial problems mounting at other state enterprises, Beijing can ill afford to have its credit shut off. In 1998, foreign banks pulled $12 billion in loans out of the country. They're expected to yank an additional $10 billion this year. That's one reason why Guangdong Executive Vice-Governor Wang Qishan, a protege of reformist Premier Zhu Rongji, is personally supervising the case and has hired Goldman. The U.S. investment bank is offering to invest up to $20 million of its own money in the company.

One mystery that lenders would like resolved is why this prominent corporation crashed so dramatically. The group is the investment arm of the booming southern Chinese province, which has had one of the world's highest growth rates for the past decade. Altogether, the group has more than 240 companies in everything from hotels and supermarkets to tin-plate manufacturing. Yet Guangdong Enterprises has been spectacularly unprofitable. The group generated just $14 million in cash flow last year. Three of the group's four core companies--Guangdong Enterprises itself, Nam Yue, and Guangnan--are bust, with debts exceeding assets by almost $1.9 billion. If they were liquidated, banks would recover only about one-quarter of the funds they lent to these companies, according to Goldman and KPMG International.

"IRREGULARITIES." It's evident that financial controls were appallingly weak. There also are suspicions of fraud and corruption. Guangnan's chairman and two senior executives quit in February after auditors reported finding "irregularities." A lower-level Guangnan manager has been a fugitive since Hong Kong's anticorruption agency charged him with graft last year. The government's unwillingness to give a full accounting also troubles creditors.

But the Guangdong government is serious about cleaning up the mess. Since December, the province has poured $180 million into Guangdong Enterprises to cover interest payments. Wang says he may continue the payments until Aug. 31. If a debt plan hasn't been finished by then, creditors could push the group into bankruptcy.

The decision to inject Dongshen into the group's Hong Kong unit, meanwhile, is important because the water supplier is highly profitable. That has broader implications for corporate reform. While mainland companies have injected assets into Hong Kong-listed vehicles for years, they usually have been weak performers. This time, Guangdong will essentially privatize one of its crown jewels. With many other big state companies near bankruptcy, a wave of similar deals could whittle down China's bad debts and shrink the state sector.

Goldman also is leaving the door open to sweetening its offer to creditors, for example by hiking the 1% rate on the $1.8 billion in interest-bearing preference shares. "There is a broad willingness to review any and all terms," says Goldman Sachs Managing Director Steven M. Shafran.

Creditors aren't dealing from a position of strength, however. They could reject the proposed deal and throw the companies into liquidation. But Guangdong and Goldman are betting the creditors would rather take their money now. "It is in nobody's interest to prolong this," contends Meocre Li, an adviser to Guangdong Investment.

The Guangdong Enterprises workout underlines what foreign banks learned during the GITIC debacle: that lending to state-owned companies can be a good way to lose money. That means foreign lenders will take a harder look at China. One U.S. banker estimates there are no more than 20 solid credit risks among mainland companies, such as major state-owned banks and the country's biggest shipping group. With fewer companies able to meet the more exacting credit standards, they'll be under greater pressure to sell assets to the private sector.

The bankers won't like their haircuts. But their eagerness to shower money on poorly run groups like Guangdong Enterprises means they'll have to share the pain of restructuring.

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