The Sunday Review

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China's financial system rocked

The collapse of Gitic raises questions not only over the health of China's 239 international trust and investment corporations, which borrow heavily from abroad, but also the country's financial system. China Correspondent MARY KWANG wades through the banking tangle

The management of the international trust and investment corporations saw 'itics' as a personal treasury, from which funds could be diverted to various ends without awkward questions being asked.

BEIJING -- The shocking closure of one of China's largest trust and investment companies, Guangdong International Trust and Investment Corporation (Gitic), is as much a moment of awakening for foreign banks which lend to Chinese institutions as it is a turning point for China's banking authorities.

Lending to Chinese entities and recovering loans will never be the same again. The Gitic case is the first collapse of a Chinese financial entity in which the government has said it would not bail out foreign lenders or grant priority to them over local creditors in debt recovery.

Gitic was the third large financial institution to be shut down last year, after China Venturetech Investment Corporation and Hainan Development Bank. In the first two cases, the government promised to settle foreign debts to avoid affecting credit ratings abroad.

The closure of Gitic, on orders from the People's Bank of China (PBOC) last October when it failed to pay its debts, continues to rock the banking circle.

Bankers are discovering the worth of letters of comfort or word of local governments as a recourse in recovering loans; the cost of a non-transparent financial system; the implications for unregistered foreign loans and the extent of debt protection afforded by China's bankruptcy rules.

The PBOC, the central bank, is learning how it has been blinded to the extent of foreign borrowings by local governments, and how nervous foreign bankers can get when loans to provinces or cities are not backed up by the government.

Drawn by higher-than-average returns, aggressive foreign banks extended credit to the international trust and investment corporations (itics), including Gitic, based on nothing but the assurances of local governments. The itics took out short-term foreign loans to service long-term projects.

One reason is that they were afraid they would not get approval for longer-term foreign loans which would have had to be registered with the State Administration of Foreign Exchange (Safe). In Gitic's case, half the US$1.93 billion (S$3.28 billion) in direct foreign debts had not been registered with Safe.

A foreign banker, who declined to be identified, says: "As long as there were institutions willing to lend to the itics, it was all right. But the day some lender says 'no', the house of cards tumbles, as in Gitic's case."

At the time of Gitic's closure, foreign lenders had a false sense of containment of their problems because Beijing gave assurances that foreign debts would be repaid. Most banks took that to mean Safe-registered loans would be recovered.

In a U-turn later, Beijing said foreign banks which had registered their loans with Safe would not be accorded priority over other creditors.

Defending the decision, central bank governor Dai Xianglong says if all registered foreign debts were paid off first, there would be nothing left for most domestic creditors such as local banks and stated-owned enterprises.

Three months of investigations showed that Gitic's liabilities were higher than had been known even by the central bank. Gitic filed for bankruptcy last month with total liabilities of US$4.3 billion and assets of US$2.6 billion.

The biggest uncertainty for lenders is what the PBOC is planning for Gitic and other big itics which may also default on repayment. Mr Dai extended a ray of hope for at least some recovery when he said a creditors' meeting was set for April.

"The seniority of repayment will be decided by the Higher People's Court but there will be a creditors' conference which may restructure Gitic's liabilities," he said last month.

The banking circle here sees in his remarks a suggestion that Gitic would not be made bankrupt but could be kept afloat and its debts rescheduled.

He tried to play down Gitic's closure when he likened the situation to that of insolvent state-owned enterprises (SOEs) in the country's ongoing state-sector reform process.

The central government has said it would no longer support loss-making SOEs which have been a drain on state coffers.

His arguments, however, failed to appease increasingly disillusioned foreign bankers. One says: "Mr Dai is wrong to compare the itics with non-financial state-owned enterprises. The itics are a window for China to borrow overseas... Most SOEs borrow instead from domestic banks."

Mr Dai says the total foreign liabilities of China's existing 239 itics, excluding Gitic, amounted to US$8.1 billion, of which US$2 billion had fallen due or were overdue. He also says many itics would not run up massive foreign debt because "most of them would only be good for up to US$50 million each".

His disclosure failed to have the intended calming effect on foreign bankers, many of whom are sceptical about the numbers he cited, especially when they realised the extent of understatement of Gitic's debts.

Gitic and similar cases like it have driven home the extent of abuses in the itics that foreign bankers had chosen to overlook because they believed they had recourse to the government through guanxi.

For instance, a Hongkong-based investment arm of Hubei province was supposed to have assets of more than US$1.5 billion. The liquidators managed to find assets worth only US$500,000 -- not enough even to cover their fees.

The itics trace their roots to 1979, soon after the launch of the late patriarch Deng Xiaoping's economic reform and opening-up policies.

Gitic was then set up to help the central government raise foreign funds for strategic projects. With government back-up, it borrowed successfully.

Soon, others mushroomed across the country. Provincial, city and county governments, ministries and large enterprises rushed to create their own itics which gave them control over funds to finance pet projects.

The number peaked at around 1,000 in 1993, in the economic boom which followed Mr Deng's call for faster economic reforms in his famous southern tour in the spring of 1992.

There are several reasons for the dire straits in which the itics now find themselves. One is the calibre of management, which has been wracked by malpractices, embezzlement and corruption.

The management saw itics as a personal treasury, from which funds could be diverted to various ends without awkward questions being asked.

Another problem was that the itics have no core business. They plunged helter-skelter into real estate, stockbroking, hotels, power plants, highway construction and other blind investments in a "what other provinces do, we can do too" kind of mentality, with underlying self-interest and corruption.

A central bank official, Mr Xia Bin, says the itics lacked purpose and a rational operational structure, had no stable source of funds, and suffered from poor internal control.

In China's still-evolving financial system, the itics have been excluded from activities that in other countries are normally undertaken by such companies.

For instance, retirement funds set up under social welfare reforms now being implemented in the country are managed instead by the Labour Ministry, Personnel Ministry and the Civil Affairs Ministry. Securities investment funds established last year are managed by stockbrokers rather than itics.

A trust law, under discussion for several years now, has bogged down the role of itics and the businesses they can engage in.

Instead, the itics have taken to stockbroking in a big way. Of the 239 itics in the country, more than 230 are in securities, which account for 60 per cent of itics' activities and helped them stay afloat.

The itics invested heavily in the Hongkong stock and property markets and domestic real estate. They suffered massive losses when values plunged in the Asian crisis and foreign banks, such as Japanese ones, withdrew credit from the region.

The currency turmoil also led the PBOC, which had started to clean up the itics a few years ago, to step up these efforts.

Chinese banking authorities have been studying causes of the crisis and noted how corporations in countries such as Thailand and Malaysia used short-term foreign loans to cover long-term financing. They are wary that the same could happen with the itics.

After the Gitic collapse, foreign banks scrambled to recall loans to other itics, creating fears of a domino effect with one itic after another declaring itself insolvent.

Any loan application from an itic is now turned down automatically by foreign banks. An Economic Daily report says a third of the 240 itics were in debt or likely to be in debt and another third could not meet obligations. One estimate is that half the itics' US$55 billion assets are non-performing.

More bad news is in the offing: Beijing has said -- and the message was reinforced recently by Mr Dai -- that it plans to bar the itics from securities trading, a move which is likely to lead to more collapses since such business represents a lucrative source of revenue, if not the only source.

The PBOC wants the itics to merge or restructure. But there are doubts about how successful such moves can be.

Sources say that after tackling the itics, the central government will set its sights on resolving the bad debts of state-owned banks.

In China's state-controlled system, the banks had lent to inefficient state-owned enterprises, many of which are unable to repay the loans.

According to a source, even experts in the central government's statistics department are unable to determine the seriousness of the banking sector's bad-debt problem "because of false statistics submitted by local governments who want to look good".

A branch manager of a state-owned commercial bank in Guangzhou says up to 70 per cent of the branch's assets were bad. "This situation is very common. Everyone's waiting. Waiting to see what the central government would do."

Mr Dai shrugged off the concerns. He says China is still attractive to investors, as evidenced by the recent successful US$1-billion global bond offering by the Finance Ministry.

He cannot deny, though, that China is paying a price for its non-transparent financial sector.

The Ministry of Finance issued the 10-year bonds at 280 points above the US treasury bond rate, when most other loans pay a premium of 50 to 60 points.

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