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Treating the Cancer of High Interest Rates in China — Caijing Magazine commentary

March 31st, 2015 No comments

caijing

The cost of borrowing money is a huge and growing burden for most companies and municipal governments in China. But, it is also the most attractive untapped large investment opportunity in China for foreign institutional investors. This is the broad outline of the Chinese-language essay published in this week’s Caijing Magazine, among China’s most well-read business publications. The authors are me and Dr. Yansong Wang, China First Capital’s Chief Operating Officer.

Foreign investors and asset managers have mainly been kept out of China’s lucrative lending market, one reason why interest rates are so high here. But, the foreign capital is now trying to find ways to lend directly to Chinese companies and municipalities, offering Chinese borrowers lower interest rates, longer-terms and less onerous collateral than in the Rmb15 trillion (USD $2.5 trillion) shadow banking market. Foreign debt investment should be welcomed rather than shunned, our commentary argues.

If Chinese rules are one day liberalized, a waterfall of foreign capital will likely pour into China, attracted by the fact that interest rates on securitized loans here are often 2-3 times higher than on loans to similar-size and credit-worthy companies and municipalities in US, Europe, Japan, Korea and other major economies. The likely long-term result: lower interest rates for company and municipal borrowers in China and more profitable fixed-income returns for investors worldwide.

I’ve written in English on the problem of stubbornly high borrowing costs in China, including here and here. But, this is the first time I tried to evaluate the problem for a Chinese audience — in this case, for one of the more influential readerships (political and business leaders) in the country.

The Chinese article can be downloaded by clicking here.

For those who prefer English, here’s a summary: high lending rates exist in China in large part because the country is closed to the free flow of international capital. The two pillars are a non-exchangeable currency and a case-by-case government approval system, managed by the State Administration of Foreign Exchange (SAFE) to let financial investment enter, convert to Renminbi and then leave again. This makes it all but impossible to arbitrage the 1,000 basis point interest rate differential between China domestic corporate borrowers and similar Chinese companies borrowing in Hong Kong.

Foreign financial investment in China is 180-degrees different than in other major economies. In China, almost all foreign investment is in equities, either through buying quoted shares or through giving money to any of the hundreds of private equity and venture capital firms active in China. Outside China, most of the world’s institutional investment – the capital invested by pension funds, sovereign wealth funds, insurance companies, charities, university endowments — is invested in fixed-income debt.

The total size of institutional investment assets outside China is estimated to be about $50 trillion. There is a simple reason why institutional investors prefer to invest more in debt rather than equity. Debt offers a fixed annual return and equities do not. Institutional investors, especially the two largest types, insurance companies and pension funds, need to match their future liabilities by owning assets with a known future income stream. Debt is also higher up the capital structure, providing more risk protection.

Direct loans — where an asset manager lends money directly to a company rather than buying bonds on the secondary market — is a large business outside China, but still a small business here. Direct lending is among the fastest-growing areas for institutional and PE investors now worldwide. Get it right, and there’s no better place in the world to do direct corporate lending than in China.

For now, direct lending to Chinese companies is being done mainly by a few large US hedge funds. They operate in a gray area legally in China, and have so far mainly kept the deals secret. The hedge fund lending deals I’ve seen have mainly been short-term lending to Chinese property developers, at monthly interest rates of 2%-3%.

I see no benefit to China from such deals, nor would I risk a dollar of my own money. A good rule in all debt investing is whenever interest rates go above 20% a year, the lender is effectively taking on “equity risk”. In other words, there are no borrowers anywhere that can easily afford to pay such high interest rates. Anyone who will take money at that price is probably unfit to hold it. At 20% and above, the investor is basically gambling that the desperate borrower will not run out of cash while the loan is still outstanding.

Interest rates are only one component of the total cost of borrowing for companies and municipalities in China’s shadow banking system. Fees paid to lawyers, accountants, credit-rating agencies, brokerage firms can easily add another 2% to the cost of borrowing. But, the biggest hidden cost, as well as inefficiency of China’s shadow banking loan market is that most loans from this channel are one-year term, without an automatic rollover.

Though they pay interest for 12 months, borrowers only have use of the money for eight or nine months. The rest of the time, they need to accumulate capital to pay back principal at the end of one year. China is the only major economy in the world where such a small percentage of company borrowing is of over one-year maturity. China’s economy is guided by a Five Year Plan, but it’s domestic lenders operate on the shortest of all time-frames.

If more global institutional capital were allowed into China for lending, I would expect these investors to want to do their own deals here in China, negotiate directly with the borrower, rather than buying existing securitized shadow banking debt. These investors would want to do more of their own due diligence, and also tailor each deal, in a way that China’s domestic shadow banking system cannot, so that the maturity, terms, covenants, collateral are all set in ways that correspond to each borrowers’ cash flow and assets.

China does not need one more dollar of “hot money” in its economy. It does need more stable long-term investment capital as direct lending to companies, priced more closely to levels outside China. Foreign institutional capital and large global investment funds could perform a useful role. They are knocking on the door.

http://magazine.caijing.com.cn/20150330/3851367.shtml

 

Blackrock, Fidelity and others learn a painful lesson about China debt pricing

March 23rd, 2015 No comments

Kaisa bonds

For all the media ink spilled, including by Reuters’ excellent Asia fixed income correspondent Umesh Desai, you’d think the ongoing fight in Hong Kong between severely-troubled Chinese real estate developer Kaisa Group and its creditors was the biggest, nastiest, most portentous blood feud the capital markets have ever seen. It’s none of that. It’s a reasonably small deal ($2.5 billion in total Hong Kong bond debt that may prove worthless) involving a Chinese company of no great significance and a group of unnamed bond-holders who are screaming bloody murder about being asked to take a 50% haircut on the face value of the bonds. The creditors have brought in high-priced legal talent to argue their case, both in court and in the media. Me thinks they doth protest too much.

Nothing wrong with creditors fighting to get back all the money they loaned and interest they were promised. But, what goes unspoken in this whole dispute is the core question of what in heaven’s name were bond investors thinking when they bought these bonds to begin with. Kaisa was, if not a train wreck waiting to happen, then clearly the kind of borrower that should be made to pay interest rates sufficiently high to compensate investors for the manifold risks. Instead, just the opposite went down. The six different Kaisa bond issues were sold without problem by Hong Kong-based global securities houses including Citigroup, Credit Suisse and UBS to some of the world’s most sophisticated investors including Fidelity and Blackrock by offering average interest rates of around 8%. If Kaisa were trying to raise loans on its home territory in China, rather than Hong Kong, there is likely no way anyone would have loaned such sums to them, with the conditions attached, for anything less than 16%-20% a year, probably even higher. Kaisa’s Hong Kong bonds were entirely mispriced at their offering.

It may strain mercy, therefore, to feel much sympathy for investors who lose money on this deal. Start with the fact Kaisa, based where I am in Shenzhen, is a PRC company that sought a stock market listing and issued debt in Hong Kong, rather than at home. Not always, but often, this is itself a big red flag. Hong Kong’s stock exchange had laxer listing rules than those on the mainland. As a result, a significant number of PRC companies that would never get approval to IPO in China because of dodgy finances and laughable corporate governance managed to go public in Hong Kong. Kaisa looks like one of these. It has a corporate structure, which since 2009 has been basically illegal, that used to allow PRC companies to slip an offshore holding company at the top of its capital structure.

The bigger issue, though, was that bond buyers clearly didn’t understand, or price in, the now-obvious-to-all fact that offshore creditors (meaning anyone holding the Hong Kong issued debt of a PRC domestic company) would get treated less generously in a default situation than creditors in the PRC itself. The collateral is basically all in China. Hong Kong debt holders are effectively junior to Chinese secured creditors. True to form, in the Kaisa case, the domestic creditors, including Chinese banks, are likely to get a better deal in Kaisa’s restructuring than the folks in Hong Kong.

This fact alone should have mandated Kaisa would need to promise much sweeter returns and more protections to Hong Kong investors in order to get the $2.5 billion. Investors piled in all the same, and are now enraged to discover that the IOUs and collateral aren’t worth nearly as much as they expected. Kaisa bonds were, in effect, junk sold successfully as something close to investment grade. As long as the company didn’t pull a fast one with its disclosure – an issue still in dispute – it’s fair to conclude that bond-buyers really have no one to blame but themselves.

At this point, it’s probable many of the original owners of the Kaisa bonds, including Fidelity and Blackrock, have sold their Kaisa bonds at a loss. Kaisa’s bonds are trading now at about half their face value, suggesting that for all the creditors’ grousing, they will end up swallowing the restructuring terms put forward by Kaisa. If the creditors don’t agree, well then the whole thing will head to court in Hong Kong. If that happens, Kaisa has threatened to default, which would probably leave these Hong Kong bondholders with little or nothing. Indeed, Deloitte Touche Tohmatsu has calculated that offshore creditors in a liquidation would receive just 2.4% of what they are owed. The collateral Kaisa pledged in Hong Kong may be worth more than the paper it was printed on, but not much.

The real story here is the systematic mispricing of PRC company debt issued in Hong Kong. It’s still possible, believe it or not, for other Chinese property developers with similar structure and offering similar protections as Kaisa to sell bonds bearing interest rates of under 9%. Meantime, as discussed here, Chinese property companies in some trouble but not lucky enough to have a holding company outside China are now forced to borrow from Chinese investors, both individuals and institutions,  at 2%-3% a month.

It’s a situation rarely seen – investors in a foreign domain provide money much more cheaply against shakier collateral than the locals will. Kaisa’s current woes are part-and-parcel of at least some of the real estate development industry in China. It seems to have engaged in corrupt practices to acquire land at concessionary prices. Kaisa got punished by the Shenzhen government. It was forbidden to sell newly-built apartment units in Shenzhen. No sales means no cash flow which means no money to pay debt-holders. Kaisa is far from the first Chinese real estate developer to run into problems like this. And yet, again, none of this, the “politico-existential” risk many real estate development companies face in China, seems to have made much of an imprint on the minds of international investors who lined up to buy the 8% bonds originally. After all, the interest rate on offer from Kaisa was a few points higher than for bonds issued by Hong Kong’s own property developers.

Global institutional investors like Blackrock and Fidelity might control more capital and have far more experience pricing debt than Chinese ones. But, in this case at least, they showed they are far more willing to be taken for a ride than those on the mainland.

China’s loan shark economy — Nikkei Asian Review

March 11th, 2015 No comments

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China loan sharking

China’s loan shark economy

PF

What’s ailing China? Explanations aren’t hard to come by: slowing growth, bloated and inefficient state-owned enterprises, and a ferocious anti-corruption campaign that seems to take precedence over needed economic reforms.

Yet for all that, there is probably no bigger, more detrimental, disruptive or overlooked problem in China’s economy than the high cost of borrowing money. Real interest rates on collateralized loans for most companies, especially in the private sector where most of the best Chinese companies can be found, are rarely below 10%. They are usually at least 15% and are not uncommonly over 20%. Nowhere else are so many good companies diced up for chum and fed to the loan sharks.

Logic would suggest that the high rates price in some of the world’s highest loan default rates. This is not the case. The official percentage of bad loans in the Chinese banking sector is 1%, less than half the rate in the U.S., Japan or Germany, all countries incidentally where companies can borrow money for 2-4% a year.

You could be forgiven for thinking that China is a place where lenders are drowning in a sea of bad credit. After all, major English-language business publications are replete with articles suggesting that the banking system in China is in the early days of a bad-loan crisis of earth-shattering proportions. A few Chinese companies borrowing money overseas, including Hong Kong-listed property developer Kaisa Group, have come near default or restructured their debts. But overall, Chinese borrowers pay back loans in full and on time.

Combine sky-high real interest rates with near-zero defaults and what you get in China is now probably the single most profitable place on a risk-adjusted basis to lend money in the world. Also one of the most exclusive: the lending and the sometimes obscene profits earned from it all pretty much stay on the mainland. Foreign investors are effectively shut out.

The big-time pools of investment capital — American university endowments, insurance companies, and pension and sovereign wealth funds — must salivate at the interest rates being paid in China by credit-worthy borrowers. They would consider it a triumph to put some of their billions to work lending to earn a 7% return. They are kept out of China’s lucrative lending market through a web of regulations, including controls on exchanging dollars for yuan, as well as licensing procedures.

This is starting to change. But it takes clever structuring to get around a thicket of regulations originally put in place to protect the interests of China’s state-owned banking system. As an investment banker in China with a niche in this area, I spend more of my time on debt deals than just about anything else. The aim is to give Chinese borrowers lower rates and better terms while giving lenders outside China access to the high yields best found there.

China’s high-yield debt market is enormous. The country’s big banks, trust companies and securities houses have packaged over $2.5 trillion in corporate and municipal debt, securitized it, and sold it to institutional and retail investors in China. These so-called shadow-banking loans have become the favorite low-risk and high fixed-return investment in China.

Overpriced loans waste capital in epic proportions. Total loans outstanding in China, both from banks and the so-called shadow-banking sector, are now in excess of 100 trillion yuan ($15.9 trillion) or about double total outstanding commercial loans in the U.S. The high price of much of that lending amounts to a colossal tax on Chinese business, reducing profitability and distorting investment and rational long-term planning.

A Chinese company with its assets in China but a parent company based in Hong Kong or the Cayman Islands can borrow for 5% or less, as Alibaba Group Holding recently has done. The same company with the same assets, but without that offshore shell at the top, may pay triple that rate. So why don’t all Chinese companies set up an offshore parent? Because this was made illegal by Chinese regulators in 2008.

Chinese loans are not only expensive, they are just about all short-term in duration — one year or less in the overwhelming majority of cases. Banks and the shadow-lending system won’t lend for longer.

The loans get called every year, meaning borrowers really only have the use of the money for eight to nine months. The remainder is spent hoarding money to pay back principal. The remarkable thing is that China still has such a dynamic, fast-growing economy, shackled as it is to one of the world’s most overpriced and rigid credit systems.

It is now taking longer and longer to renew the one-year loans. It used to take a few days to process the paperwork. Now, two months or more is not uncommon. As a result, many Chinese companies have nowhere else to turn except illegal money-lenders to tide them over after repaying last year’s loan while waiting for this year’s to be dispersed. The cost for this so-called “bridge lending” in China? Anywhere from 3% a month and up.

Again, we’re talking here not only about small, poorly capitalized and struggling borrowers, but also some of the titans of Chinese business, private-sector companies with revenues well in excess of 1 billion yuan, with solid cash flows and net income. Chinese policymakers are now beginning to wake up to the problem that you can’t build long-term prosperity where long-term lending is unavailable.

Same goes for a banking system that wants to lend only against fixed assets, not cash flow or receivables. China says it wants to build a sleek new economy based on services, but nobody seems to have told the banks. They won’t go near services companies, unless of course, they own and can pledge as collateral a large tract of land and a few thousand square feet of factory space.

Chinese companies used to find it easier to absorb the cost of their high-yield debt. No longer. Companies, along with the overall Chinese economy, are no longer growing at such a furious pace. Margins are squeezed. Interest costs are now swallowing up a dangerously high percentage of profits at many companies.

Not surprisingly, in China there is probably no better business to be in than banking. Chinese banks, almost all of which are state-owned, earned one-third of all profits of the entire global banking industry, amounting to $292 billion in 2013. The government is trying to force a little more competition into the market, and has licensed several new private banks. Tencent Holdings and Alibaba, China’s two Internet giants, both own pieces of new private banks.

Lending in China is a market rigged to transfer an ever-larger chunk of corporate profits to a domestic rentier class. High interest rates sap China’s economy of dynamism and make entrepreneurial risk-taking far less attractive. Those looking for signs China’s economy is moving more in the direction of the market should look to a single touchstone: is foreign capital being more warmly welcomed in China as a way to help lower the usurious cost of borrowing?

Peter Fuhrman is the founder, chairman and chief executive of China First Capital, an investment bank based in Shenzhen, China.

 

http://asia.nikkei.com/Viewpoints/Perspectives/Chinas-loan-shark-economy

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