Beijing: Look Out, Deadbeats

China is finally starting to break the bad-debt logjam

It's an investment for the brave--or the foolish. One factory makes bicycles, another produces coal-mining equipment. A third makes refrigerators. A distillery pumps out China's powerful maotai liquor. All of them are crippled businesses, burdened by outmoded manufacturing processes, overstaffing, and, worst of all, mountains of unpaid debt. Yet mighty investment bank Morgan Stanley Dean Witter & Co. has just staked a claim on each of these businesses--and more than 200 others--in a ground-breaking fire sale of the bad debts of some of China's most dysfunctional companies.

Morgan Stanley bought the unpaid debt from Huarong Asset Management Corp., a state-run investment vehicle that took over the dud loans from The Industrial and Commercial Bank of China. A consortium led by New York-based Morgan Stanley paid Huarong 8 cents on the dollar--about $100 million--for $1.2 billion worth of bad paper. The November asset auction was the first ever involving an international group of investors. "We hope that this will open the gates for all the other asset management companies to start selling," says G. David Bednar, a Hong Kong-based Morgan Stanley executive director who spearheaded the deal. Bednar, a distressed debt specialist previously based in New York, beat off competition from a group led by Goldman, Sachs & Co. to win the deal. The Morgan Stanley group includes a Hong Kong firm and a Chinese company with debt workout expertise; part of their role will be to help make the deal profitable without entangling participants in Chinese courts any more than necessary.

NO SHORTAGE. Goldman and others may yet have their day--because there's a lot of bad paper to sell in China. China's banks and asset management companies hold more than $400 billion in nonperforming loans. The lousy loans are a legacy of decades of central planning, when banks shoveled money into badly run state-owned companies. For economic reform to succeed, China has to cut off deadbeat borrowers, dispose of their bad loans, and channel bank capital to more deserving enterprises. Solving the bad loan problem "is key to sustaining China's high economic growth," says C.G. Wu, the Morgan Stanley managing director in charge of its China investments.

To kick off this process, the country's four asset management companies (AMCs) have taken over more than $170 billion in bad loans in the last two years, with each firm picking up loans from one of China's Big Four banks. But the asset managers haven't taken the strong action, such as closing down factories and forcing the ouster of ineffective executives, needed to work out the debt. Critics charge that the AMCs' proudest accomplishment--acquiring equity stakes in some 600 companies in return for wiping out some debt--just gave the asset managers stock of dubious value and resulted in no management shakeups at the debtor firms.

But the sale by Huarong pushes the workout process forward. "Selling off these bad assets shows the authorities are serious about creating a proper credit culture," says Karin Finkelston, China country manager for International Finance Corp. IFC, a World Bank affiliate, is providing a credit guarantee for 40% of the Morgan Stanley deal's financing. The guarantee will help the group get lower cost loans from Chinese banks.

Huarong President Yang Kaisheng declares himself "very satisfied" with the deal. He says it is just a "rehearsal" for future efforts to sell to foreigners more of the $60 billion in bad assets Huarong holds. And Yang wants to move quickly to avoid what he calls the "ice cream" effect. "As time goes by, the value of the loans melts," he notes.

One big unknown is whether anyone from inside or outside China can make the local deadbeats pay. Morgan Stanley and its co-investors, which include Lehman Brothers Inc. and Salomon Smith Barney, were the only survivors among 15 groups that first expressed interest in the Huarong debt. Difficulty in figuring out everything from how well China's legal system would back creditors to valuing individual assets caused most to drop out. "You'd go out to a piece of collateral, and there's just one guy there with a broom in front of a factory that's been closed for three years," says a banker who looked at some Huarong properties.

Undaunted, Morgan Stanley is jumping in. Through a complicated formula, its joint venture with Huarong will give the AMC a share of the profits from any debt workouts that succeed. Many of the venture's 25 to 50 employees will be drawn from Huarong's ranks; one of Yang's goals is for Morgan Stanley to help teach his staff how to do loan workouts on their own.

RECOVERY OPERATION. Morgan Stanley is shooting for annual returns of about 25% on its investment. To achieve that, the firm is ready to do whatever is necessary, including legal action, to renew payments on nonperforming loans. The deep discounts it won in acquiring the paper mean Morgan can score big even if debtors pay only a fraction of what they owe. One likely candidate to restart payments is a Shenzhen-based conglomerate with $400 million in sales and operations ranging from oil and gas storage to rail transport. Another is a printing company equipped with high-end German presses. As a last resort, Morgan Stanley is willing to shut down plants and sell off the physical assets. "That's part of recognizing reality," says Bednar.

Ernst & Young Managing Director Jack Rodman, who brokered the deal for Huarong, expects to sell an additional $615 million tranche of Huarong debt to foreigners by the end of the year. He also hopes to persuade officials at China's giant state-owned banks to let him help sell off their bad debts directly, without going through the AMCs. "They've accomplished a lot," says Rodman of the Chinese authorities. In China, he adds, "I see more direct dealing with the problems" than in Japan, Korea, and Thailand.

Impressive, yes. But even with $1.2 billion down, there's more than $400 billion still to go. China has just taken a single step in a marathon. "The real question is whether China will stay the course," says Rodman. Beijing has to keep moving to win over the doubters. But at least it can be said that it has bolted out of the starting blocks.

By Mark L. Clifford in Hong Kong, with Alysha Webb in Shanghai

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