Recent press reports have noted the mounting levels of distressed debt in China at a time when the country’s GDP growth has plummeted to its lowest level in a decade (albeit still at 6%). Bloomberg has highlighted that non-performing loans (or NPLs) in China exceeded 2500 billion Yuan (the equivalent of US$365 billion) by the end of 2019, more than doubling in the last five years alone due to the economic slowdown and, more recently, the trade dispute with the US. In headier times, China’s troubled companies were regularly propped up by Chinese asset management companies (or AMCs) that were created for that purpose – to prevent borrower distress from stalling the country’s economic growth. These AMCs — often referred to as “bad banks” — include China Orient Asset Management Co. (matched with Bank of China) and China Cinda Asset Management (matched with China Construction Bank) and were organized to allow banks to discard their distressed portfolios in a manner both protective of the banks and the borrowers. In recent years, however, with the greater need for constraint that comes with rapidly slowing GDP growth, more borrowers may be allowed to fail and with that, there should be a need for new participants in the market for Chinese NPLs.
One element of the new “phase 1” trade deal with China has been somewhat overlooked. Buried within the agreement rests Article 4.5 which provides that: “China shall allow U.S. financial services suppliers to apply for asset management company licenses that would permit them to acquire non-performing loans directly from Chinese banks…. When additional national licenses are granted, China shall treat U.S. financial services suppliers on a non-discriminatory basis….” While terse, the provision seems intended to afford US financial institutions significantly greater access to the Chinese distressed debt markets upon acquisition of relevant licenses. This comes at a time when distressed debt opportunities are often difficult to find in the US as distressed loans held by commercial banks have continued a steady decline since the financial crisis (approximately $85-95 billion as of Q3 2019). While opportunities in China have existed previously, US firms were generally restricted to acquiring limited debt portfolios from the AMCs, rather than acquiring individual loans from the original lenders. Pilot programs allowing for direct acquisition were enacted by some AMCs but were extremely narrow in their scope. New opportunities in China should excite US distressed debt investors. Under the new trade deal, and subject to satisfying certain regulatory hurdles, US funds should be permitted to acquire debt directly from Chinese banks (if implemented as seemingly intended). It is likely that initial interest will come from the bravest, most sophisticated investors – likely, those that are already participating in the Chinese market in some fashion. Of course, acquisition of Chinese NPLs will require a deep understanding of the local legal system, including particularly its relatively nascent restructuring regime. Secondary market purchasers will also want to organize acquisition vehicles in tax efficient jurisdictions. While the process must certainly further develop, those US investors that show the ability to work well with Chinese banks and asset management companies, may find a new, largely untapped market in Chinese NPLs from the implementation of this month’s “phase one” trade deal.