As we enter the Year of the Sheep, the media has been brimming with news of booming debt levels in China and the opportunity this may create for some of the world's largest investors. Could the Chinese debt market finally be opening up in 2015? It is a little over a decade since we witnessed the first foreign distressed investor foray into China. Deals were done with China's AMCs that had been established in a futile attempt to overcome a mountain of toxic loans in the banking sector. That time, the AMCs failed miserably to achieve what was expected from them, whilst the investors ended up going home empty-handed. Why should anything be any different this time, other than the scale of the Chinese debt being fifty times bigger? For distressed investors, will China 2015 be remembered as the Year of the Sheep or the Year of the Lambs to the Slaughter?
Buying NPLs- Price, Price & Price
The core problem that has always plagued foreign NPL investors in China is price. Chinese AMCs overpaid the banks for loans and the resulting bid-ask spread discrepancy with potential foreign buyers has prevented the NPL business from properly opening up. Fundamentally, Chinese AMCs were not incentivized to maximize NPL collections. They ended up habitually selling off the best loans to local "sweetheart" investors. Now in 2015, when it comes to servicing, local asset managers in China have no experience of maximizing NPL collections in a troubled market. Chinese AMCs, during the past bull market, have made their profits by diversifying into other flourishing market areas such as finance, leasing, insurance, the trust business and securities brokerage. Given their paucity of loan servicing skills and having rapidly expanded into sectors that will be hit badly by downturn, betting on Chinese AMCs looks to be an extremely high risk gamble, unless it is for short-term IPO style gain, or it is the principals making a killing on their way to the exit.
Goldilocks or the Three Bears?
It seems that Chinese AMCs can only now avoid calamity in the event of the so-called "Goldilocks" economic scenario emerging: an environment that continues to produce NPLs in a market that is still strong enough to drive value gains. Such a situation cannot be engineered, and would depend upon an enormous slice of luck that only the most optimistic would bank on. It has parallels with the "holy grail" of China's economy transitioning from being export-led to consumption-led. Given the current global deflationary environment, deteriorating Chinese economic news and the distinct likelihood of the mother of all credit bubbles imploding, China looks more and more like it will struggle to transition, which makes it even more dependent upon exports for recovery.
Asian Bad Debt Levels Rising
Bad debt levels are mounting in most of Asia, stoked by currency tension, and the market cycle, given there have been 15, mostly boom years, since 1997. The choice facing distressed investors in Asia now is one of scale. We calculate NPLs in ASEAN banks to currently top US$230 billion whilst NPL levels in Chinese banks total many trillions of dollars. The largest global investors are understandably drawn to the bigger investment volumes, but they also need to appreciate that the more alluring investment amounts also carry colossally higher risks.
Unlike China, much of ASEAN has a 15-year successful track record of inward investment by some of the world's largest and best-governed institutions. ASEAN has also experienced at least one market crash and sustained recovery cycle, rendering the Chinese market a primitive, pioneer, debt frontier by comparison. Buying distressed debt in China is like venture capitalism; buying distressed debt in much of ASEAN is statistically predictable, and in cases, can be more akin to insurance product underwriting in terms of its risk profile.
Local Banks Out, Foreign Investors In
After the 1997 Crisis foreign investors in ASEAN were able to exploit gaps left by calamity in the local banking sector. In addition to buying NPLs, foreign investors were able to successfully colonize sectors such as senior lending, mezz lending, high yield, corporate restructuring, M & A, and gap financing. Rich pickings were available for a 5-year period until the banks rebounded. Once the local banks were back in business, foreign investors were unable to compete on price, risk levels and valuation and withdrew. Now in 2015, as debt levels peak in domestic banks, and they pull back on lending, it is clear that opportunities are opening up again for a wide variety of foreign investors in the ASEAN finance sector for institutions, funds, private equity and family offices.
NPL Opportunity of the Decade?
Government AMCs are generally established in order to manage a better disciplined recycling of bank NPLs. By definition, they overpay for NPLs by comparison with market-driven NPL investors. If the banks were able to accept investors paying market value for clearing NPLs, there would be no need for government AMCs. In addition to the AMCs in China, the Vietnamese government has recently established Vietnam Asset Management Company (VAMC), and in Thailand the government is a major shareholder in Bangkok AMC and Sukhumvit AMCs. (BAM and SAM). Government owned, sponsored or financed AMCs are dependent upon ongoing central financial support, generally through bond issuance, in order to continue their NPL purchasing activities. The difference between western markets and much of Asia is that the latter does not have a Federal Reserve or an ECB to continue bail-out indefinitely for AMCs and the banking sector.
Overpaying for NPLs succeeds for Government AMCs in a benign market, or as long as new growth continues to paper over the cracks in their balance sheets. As long as the music continues to play, they appear sound, but as soon as the music stops, major, fundamental faults materialize. As long as government can afford to, and is prepared to bail out the AMCs, they continue to look solid, but as soon as support is removed, government AMCs themselves may well end up being one of the very best NPL investment deals of the decade for foreign distressed investors.
