Since the beginning of April, the prices of offshore dollar-denominated bonds issued by China Huarong Asset Management Co – one of the four national asset management companies (AMCs) tasked with acquiring nonperforming loans (NPLs) from China’s banks – have been falling on expectations that the company may face bankruptcy.

For the time being, rumours of Huarong's imminent bankruptcy are purely conjecture. On Friday, the China Banking and Insurance Regulatory Commission (CBIRC) sought to reassure markets, saying that, “Operations at Huarong remain normal and the company has ample liquidity.” Meanwhile, Reuters has reported that the CBIRC has moved to head off liquidity risks, telling banks not to withdraw funding from Huarong.

Still, a restructuring of Huarong would be a major event. 

The AMC is about 70% larger than Hengfeng Bank, which is the biggest financial institution to have been bailed out by the authorities in recent years. 

Moreover, of the $42bn Huarong has raised in the bond markets, $23.2bn is from overseas. Crucially, Huarong is 57% owned by China's Ministry of Finance (MOF), which at one time would have made the possibility of restructuring incredibly unlikely. However, with Beijing trying to break the market's belief that state firms are backed by an implicit guarantee from the government, Huarong's bondholders face the prospect that they might have to accept a haircut on their debt.

Huarong's problems aren't new. Rather they're born from reckless lending and overambitious expansion during the years following the Global Financial Crisis when China's financial regulators were unable to keep risk-taking in check. That those problems are coming to a head now could presage a challenging year ahead for regulators. 

After a spate of bank bailouts in 2019, financial sector risk was papered over in 2020 by an increase in credit growth and other policies to help see firms through the pandemic. 

Now that the Covid-19 crisis is over, Beijing is demanding that macro leverage levels – that is the percentage of debt relative to the size of the economy – remain basically unchanged this year. While such constraints on debt are good for long-term financial stability, they could limit the ability of overstretched institutions – like Huarong, but also firms that borrowed to get through the pandemic – to tap the liquidity they need to meet their debt obligations. It could also mean that bank stress picks up where it left off immediately prior to the coronavirus outbreak.

It's important to keep in mind that for the time being, any talk of a Huarong bailout or restructuring is pure speculation. However, given the size of the undertaking and the impact on both domestic and offshore markets, it's worth considering what form it might take and how it might impact China's bank cleanup efforts.

God of Wealth 

On March 31, Huarong failed to meet the deadline for Hong Kong-listed companies to publish their 2020 earnings reports. Its shares were promptly suspended from trading, and the prices of its bonds started to decline. However, the selloff became a rout only after Ling Huawei, managing editor of Caixin, wrote a column on April 13 in which she brought the rumours into the open, posing the question "Can Huarong go bankrupt?"

The firm’s difficulties have been building for some time. Huarong and the other three national AMCs were originally supposed to be wound down in 2009 – 10 years after their establishment – on the assumption that a decade was sufficient time in which to dispose of the bad loans they'd acquired during a banking crisis at the turn of the century. But instead, they managed to convince the authorities to let them carry on and evolve into financial holding companies. They set about building financial services businesses – in banking, securities, futures, leasing, trusts – many of the licenses for which they'd already acquired in the course of dealing with distressed firms.

Huarong, under its then-Chairman Lai Xiaomin, was more aggressive than its peers, expanding into not only financial services but also shadow banking. Lai – who came to be known in some circles by the moniker "God of Wealth" – also exploited Huarong for his own gain. Lai was detained by the authorities in 2018 and executed in January this year after being found guilty of taking Rmb1.8bn in bribes. 

Under Lai, Huarong made loans to some of China’s most notorious corporate failures, notably HNA Group, financial conglomerate CEFC China Group, solar panel producer Hanergy, Dandong Port and Huishan Dairy.

“Some believe that Lai’s misconduct as chairman left Huarong with a huge financial black hole,” Caixin's Ling wrote in her column. “It’s unrealistic to expect Huarong to fill that hole all on its own.”

Filling the hole

Huarong is of strategic importance to the central government – but only parts of Huarong. As a national AMC, Huarong is essential to recent efforts to clean up banks' bad loans. At the time Huarong started diversifying into financial services, bank NPLs were at a record low and there was little use for the AMCs. But since 2016, the banks have been accelerating their disposal of NPLs as part of a broader cleanup of the financial system. Last year, disposals increased by about 30% to more than Rmb3trn, and the banking regulator has said that in 2021 they will be at least as large. 

Consequently, it's reasonable to expect that any restructuring of Huarong will involve stripping the company back to its core function in order to preserve the experience and expertise of its NPL disposal operations. In fact, the authorities have already tried nudging Huarong in this direction, with limited success.

Soon after Lai was detained, financial regulators instructed the four national AMCs to refocus their activities on NPL disposals. However, since then the volume of bad loans acquired by Huarong has declined precipitously. In 2016 and 2017, it was unequivocally the most active acquirer of banks’ bad loans. However, its purchases plunged in 2018, and in 2019 they were about a quarter of their peak. 

Huarong needs to be recapitalised – and unencumbered of its other functions – in order to properly fulfil its NPL mandate.

Restructuring Huarong will be no small feat. At the end of June 2020, Huarong had Rmb1.73trn in total assets. By way of comparison, Hengfeng Bank – the largest of China's recent bank bailouts – had Rmb1.05trn in assets immediately prior to its restructuring in 2019.

It seems most likely that Huarong will start by trying to sell off its subsidiaries, which include a 40.5% stake in a bank (Huarong Xiangjiang Bank), 72% of a securities brokerage (Huarong Securities), and 76.8% of a trust company (Huarong International Trust). Beyond that, we can look to recent bank bailouts for clues as to what fate might lie in store for Huarong.

It is fair to assume that any restructuring will involve Huarong's bad loans being spun off to a third party, albeit not at market rates. 

Hengfeng's restructuring involved Rmb143.9bn yuan worth of bad loans being acquired by Shandong province's local AMC for 55 cents on the dollar (NPLs currently sell in China's secondary market for between 20 and 30 cents on the dollar). When the Bank of Jinzhou was bailed out in early 2020, Chengfang Huida – a little-known distressed debt investment vehicle set up by the central bank in 2005 – was mobilised to acquire the bank's NPLs and then replenish its capital.

What's left over?

If Huarong requires a capital injection, it seems likely that it will come from Central Huijin Investment. Huijin is the subsidiary of China Investment Corp — China’s sovereign wealth fund — that holds the central government’s bank shareholdings. Huijin provided Rmb60bn of the Rmb100bn used to recapitalise Hengfeng. Bloomberg has reported that MOF is considering transferring its stake in Huarong to Huijin. On paper such a transfer appears to be little more than an internal shuffling of state assets. However, Huijin has experience as a bailout vehicle. Meanwhile, MOF is likely trying to avoid writing down the value of assets on its balance sheet, as it might have to do if Huarong is restructured. 

Notably, Beijing has no compunction about wiping out equity held by foreigners. 

Singapore-based United Overseas Bank saw its 13.2% stake in Hengfeng eroded to almost zero during the bailout. It put up Rmb3.3bn as part of the bailout, giving it a 3.3% stake in the restructured Chinese bank.

Far less certain is what might happen to foreign bondholders. Neither Bank of Jinzhou's nor Hengfeng's creditors – most of which were other banks that had lent through the domestic interbank market – were required to take a haircut. That said, some banks that lent to Baoshang Bank – which was taken into conservatorship by financial regulators in May 2019 – weren't made whole. Although there's little publicly available information, the Bank of Gansu disclosed that China's deposit insurance fund guaranteed 90.7% of its loans to Baoshang. Bank of Gansu took impairments on the remainder.

Where Huarong differs is that most of Huarong's bondholders are institutional investors, not banks. Beijing may have opted to limit the pain of Baoshang's creditors – and spared Jinzhou's and Hengfeng's altogether – in the interests of banking sector stability. Such considerations don't apply to Huarong.

Huarong's creditors likely invested in the AMC's bonds in the expectation that there was zero chance of a firm controlled by MOF ever being restructured. Even a few years ago such an expectation would have been perfectly reasonable. However, Beijing has been trying to wean the bond market off its belief that all debt issued by state-owned institutions is implicitly guaranteed by some level of government. 

Forcing a haircut on Huarong's bondholders would send a clear message that investors in China's capital markets need to do a better job of pricing risk. However, if any distinction were made between various types of investor – for example onshore versus offshore – this would clearly send a very different signal.   

Bad loans at bad prices

It’s uncertain what impact distress at Huarong might have on the NPL market. The role of the AMCs is to acquire bad loans in bulk from commercial banks, then either sell them onward to third-party investors or resolve the loans themselves. In 2017, there was a bubble in NPL prices with domestic distressed debt investors – having raised funds from shadow banking sources – willing to pay inflated prices. However, the bubble burst in early 2018 as shadow banking contracted. 

All of the AMCs have NPLs acquired during the bubble that they haven't been able to dispose of without taking a loss – and so have declined to sell. That could change for Huarong if it finds itself under pressure to pay creditors. In fact, the AMCs have so far avoided unloading bank NPLs at the fire sale prices common during banking sector cleanups in other countries. 

But if Huarong feels compelled to slash prices, and the other three AMCs follow its lead in order to remain competitive, then new opportunities could emerge for distressed debt investors.

Conclusion

In the weeks ahead it will become clearer whether Huarong requires some sort of intervention. However, it's worth noting that the wave of distress that hit China's banks in 2019, before ending promptly thanks to pandemic relief measures, is about to swell again. As Beijing normalises economic policy and credit conditions tighten, strains at financial institutions are likely to resurface. The source of Huarong's problems is unique, but the timing of its current stress signals that we're about to pick up where things left off prior to Covid-19.

At this stage, our assessment is that any potential restructuring of Huarong is unlikely to turn into a Lehman moment for China. But the manner in which policymakers deal with the AMC will give valuable pointers of the direction of travel as Beijing deleverages at the same time as it tries to make its financial system more robust and better able to price risk properly. If China were to accomplish that latter goal, new opportunities would open up for investors in distressed debt. After all, every cloud has a silver lining.