Paper chase

In the spotlight: Sasac’s boss Jiang Jiemin has bankers worried

When Lehman Brothers closed its doors in 2008 it earned a dubious accolade as the biggest corporate bankruptcy in American history. According to MarketWatch, it owed $613 billion, far exceeding the debts of the previous record-holder WorldCom, which had borrowed $41 billion.

A corporate default in China is also getting attention, although not because it rivals Lehman in scale. The shock is more about the parties involved – large state-owned enterprises, which have typically been seen as immune to the bankruptcy threat in the past, and viewed by bankers as a safe credit risk.

The case involves one of the coutry’s largest companies, MCC (Metallurgical Corporation of China), as well as a lesser-known but significant firm called CCT (China Chengtong). MCC is a huge player in natural resources with mines in places as far flung as Afghanistan and Papua New Guinea (see WiC41 for a profile). However, it has been drawn into a messy dispute with a unit of its SOE cousin, Citic. As we discussed in WiC163, the pair have been arguing over Citic Pacific’s claim for billions of dollars in compensation after MCC failed to deliver construction work on schedule at a huge mine in Australia’s Pilbara region.

As the dispute escalated in the second half of last year, MCC began disposing some of its businesses – such as a steelmaking subsidiary – with the aim of getting losses, as well as debts, off its books.

It was just such a deal – agreed with Sasac in late 2012 – that sparked the current problems with the banks. According to the Economic Observer, Sasac gave its approval for MCC to sell its paper-making subsidiary to CCT, offloading its equity to its fellow SOE free of charge. This may have been designed to free up financial resources for a settlement with Citic. Along with the paper firm’s equity, MCC likewise transferred Rmb12.68 billion ($2.1 billion) of debt owed to 29 local banks.

What happened next is what caused the uproar. In June, MCC Paper’s Shangdong-based production facility Yinhe Paper stopped repaying its loans. The banks say CCT has told them the unit is now bankrupt, hence the debt default.

This seems to have come as a genuinely shocking event to the lenders and by late July the banks had appealed to the Beijing Banking Association to arbitrate the dispute. Several went to court to sue for their money back too.

As a representative from Beijing Rural Commercial Bank told the Economic Observer: “This behaviour is very irresponsible. The view among Chinese banks that there is no risk in lending to central enterprises [i.e. the largest SOEs controlled centrally from Beijing by Sasac] has undergone tremendous change.”

The newspaper also says that some of the banks are no longer issuing credit to Sasac-controlled SOEs, partly in protest and partly due to suspicions that some of these entities may have been given permission to default. What the bankers fear is that Sasac – the state holding company (see WiC45 for more) – is initiating a wave of debt restructuring within its portfolio with a strategy to force the banks to write down a large chunk of outstanding loans.

This brings us to CCT’s role in proceedings. Originally an SOE involved in logistics and warehouse management, CCT was given a fresh mandate in 2005. Sasac wanted to use it to acquire and then turn around failing state firms. Since then, CCT has taken over China National Packaging Corporation and China Record Corporation, among others.

In this particular case, CCT seems to have tried to cherry-pick the parts of MCC’s erstwhile paper business that it considers as going concerns. But it has let the Yinhe subsidiary go bust, vaporising much of MCC Paper’s overall indebtedness. As far as strategies go for returning a business to profitability, it’s fast and efficient. But the problem is that the financial pain is transferred to the banks.

One banker told Sina Finance that the default is ominous as it could mark a broader trend. “Do CCT’s actions indicate that a new round of state-owned enterprise debt-evading is about to start?” he asks. “If so, this round of reform will once again see the state-owned banks pay the bill for state-owned enterprises.”

That means that the debt debacle triggered by MCC, Sasac and CCT could have broader consequences. In the short term it has made the banks nervous about their exposures to large but loss-making SOEs, changing their assumptions about what they previously considered as gilt-edged credit risk. And the MCC Paper case is impacting all the banks, not just the smaller players. For example, three of the firm’s main creditors are Agricultural Bank of China, China Development Bank and Bank of Communications.

The worry for management at the weaker SOEs is that this could also lead to a liquidity crunch. The Financial Times cited an example of a company with very similar fears this week. State-owned chemicals firm Yunwei grew its assets 30-fold over the past decade, largely through debt. But thanks to overcapacity in its sector, Yunwei is in dire straits, having lost Rmb1.2 billion last year. It requires fresh debt just to stay in operation, but new financing is now becoming harder to secure.

An executive with Yunwei told the FT that the firm used to be able to borrow at the (very low) benchmark rate. Back then, he says, the creditworthiness of state-owned companies was universally seen as very good. Now, he implies, the banks aren’t so sure, which means that they are demanding that Yunwei pay 30% above the benchmark rate for new loans – so as to compensate for the higher default risk.

Of course, commentators have been arguing for some time that China must adopt more market-driven pricing for loans. Critics have also derided the relatively easy ride enjoyed by SOE borrowers in the past, especially compared to their private sector rivals.

But the question is also how reforms may end up damaging many of those caught up in the former status quo. Whether MCC Paper is the proverbial canary in the coal mine signalling some (very) bad news for the banks remains to be seen. But a number of analysts have already seized on the case to make some fairly dire forecasts. Using the bad loan write-offs of the 1990s as a guide, they say that up to a fifth of lending could default, equating to Rmb21 trillion or 40% of GDP, the FT reports.

Some form of debt restructuring already looks inevitable, given that the IMF has calculated that the average debt-to-equity ratios for Chinese firms stand at 110%.

But the precedent set by MCC Paper must have bankers worried. According to the Economic Observer, the CBRC (the banking regulator) is also increasngly concerned by the default, after being lobbied heavily by financiers to act on their behalf. Behind the scenes, a bureaucratic struggle may even be underway with Sasac, with each side seeking to protect its own interests as best it can.

The compromise reached – i.e. if banks accept a haircut of, say, 50% – could prove revealing for the slew of analysts now modelling just how bad China’s non-performing loan situation could get.

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