Why China’s bad bank has some investors rattled

A state-backed bank in China, created to clean up bad loans in the wake of the Asian financial crisis, is in trouble. And it might not be bailed out. John Stepek explains what’s going on, and why it matters.

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Today we turn to China, and a big bad bank that has been rattling credit markets over there. China Huarong Asset Management is a financial company backed by the Chinese state. It was set up in the late 1990s as a “bad bank”.

A “bad bank” is a dumping ground. It buys up toxic assets from other banks to help them to clean up their balance sheets. The bad bank then gradually processes these assets one way or the other, over time (some toxic assets turn good, others will just default and be worth nothing).

The point is to isolate and enable a managed run-off of dodgy assets, in order to prevent a systemic meltdown or to help with the recovery in the wake of one. In this case, Huarong was part of a clean-up of bad loans that followed the Asian financial crisis of the time.

The group went on to do a lot more than just buying and restructuring bad debt. Lai Xiaomin took charge as chairman in 2012 and expanded Huarong into other areas of finance including investment banking and property. In 2015 it listed in Hong Kong, attracting plenty of big international investors.

But then Lai fell from grace. He was arrested in a crackdown on corruption in 2018. He was found guilty of taking bribes in January this year (and also of bigamy, incidentally). He was executed shortly afterwards.

Of course, this cast something of a shadow over the company. As Bloomberg reports, “at Huarong, the bottom has fallen out. Net income plummeted 95% from 2017 to 2019”. Combine that with all the low-quality lending that also apparently went on under Lai, and you have a recipe for trouble.

And that’s what appears to be coming to a head now. Huarong warned earlier this month that its 2020 results would be delayed. This week, fears grew that the company was planning a big restructuring. More importantly, speculation in the Chinese press suggested that it might even end up going bankrupt.

That clearly would not be good news for anyone holding any of the roughly $23bn in dollar-denominated debt outstanding. The value of that debt fell sharply at the start of this week.

You might wonder why this has only now become an issue. It’s pretty simple though: everyone knows that bad debt is a problem in China. And in recent years some state entities have even been allowed to default on their debts.

But the assumption has always been that the Chinese state would always bail out a big, systemically-important state-controlled enterprise like Huarong. As a result, foreign investors have been happy to lend them money.

As Bloomberg quotes one analyst as saying, “a default at a central state-owned company like Huarong is unprecedented”.

So is it likely to happen now? And why is it more widely relevant?

In the long run, allowing more defaults is good news

In terms of what happens with Huarong, it’s not anything most of us need to worry about as investors. You almost certainly don’t own the bonds and it’s unlikely to have a huge impact on anything you do own.

And even the owners of the bonds don’t seem likely to take too big a hit. Most analysts seem to think that Huarong matters too much and that a full-on default might trigger a chain reaction, which the Chinese state would of course, want to avoid.

So a restructuring is more likely, whereby perhaps another bad bank is created to take the bad assets from the original bad bank, as analysts at Gavekal point out. And while international bond investors might have to take a “haircut”, it won’t be “so big that it inflicts longer term damage on investor confidence”.

In the longer run, the fact that China is trying to encourage a bit more discrimination in terms of lending is a good thing – just because bad debts can be hidden in a financial system doesn’t mean that there aren’t consequences.

Tight control means that you might not get a “Lehman Brothers” moment. But if you keep throwing money at unproductive projects and borrowers who can’t pay the money back, that’s going to hurt your economy.

As Freya Beamish of Pantheon Macroeconomics points out, “officials are well aware that China cannot afford any further build-up of bad debts, precisely because the economy is already vulnerable from this perspective.” Hence the decision to steadily allow more defaults.

But it’s a tricky balancing act. As Bloomberg reports: “Chinese authorities have tried to strike a balance between instilling more market discipline and avoiding a sudden loss of confidence that might spiral into a crisis.”

The bigger issue in the shorter term for the average investor might be that efforts to get rid of some of this bad debt (and avoid more building up) may have an effect on economic growth in China.

That’s more significant given China’s importance to global growth overall. For now, it doesn’t look like being a problem (although note that while China’s GDP growth bounced back in the first quarter of this year, it actually missed expectations).

But it’s another risk to keep an eye on, and no doubt one we’ll be writing more about in the near future in MoneyWeek. If you’re not already a subscriber to the magazine, you can get your first six issues absolutely free here.

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