China’s enormous bad debts may mean good times for bankruptcy experts

China’s solar companies’ liabilities are heavy.
China’s solar companies’ liabilities are heavy.
Image: Reuters/stringer
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Opinions remain divided about the health of China’s economy and the country’s future growth prospects, but one thing is for sure—the country’s debt load is massive—and it’s growing fast.

Overall debt now totals 250% of the country’s GDP (paywall), according to a Standard Chartered report released this week, up from 234% just six months ago. That puts China’s debt-to-GDP ratio at a level only seen in developed economies like the US and Japan. “China has become indebted before it has become rich,” Chen Long, an economist at research firm Gavekal Dragonomics, explained to the Financial Times. Chinese companies have $14.2 trillion in outstanding loans, S&P said recently, the most of any country in the world.

The growth in borrowing is being accompanied by a rising tide of delinquent and non-performing loans, according to bankers and analysts, which threatens to create a spiraling problem for their creditors, investors and customers, not to mention the economy as a whole.

But a group of distressed debt specialists that honed their skills on companies from General Motors to Lehman Bros. to Kmart—some of the developed world’s largest business failures—are looking to China for their next boom. McKinsey, Alix Partners, KPMG and numerous law firms are hiring and moving bankruptcy and restructuring experts into the region, while investors including Goldman Sachs and Warburg Pincus are jockeying to buy stakes in China’s homegrown bad-debt managers.

During China’s last bad-debt shakeout, as the government prepared state-owned banks for global IPOs in the first half of the last decade, Chinese banks offloaded more than $300 billion in bad loans. It wasn’t exactly a distressed-debt bonanza; loans weren’t deeply discounted, and the government seldom pushed insolvent debtors into bankruptcy, so it was hard for asset management companies to collect on collateral, let alone to profit.

This time, things will be a little different. Companies “will be allowed to fail,” predicts Jeffrey A. Blount, a Beijing and Hong Kong-based lawyer with Norton Rose Fulbright. In China’s carefully-controlled economy, that could be painful medicine that is ultimately good news. The alternative is a crop of “zombie firms,” like the kind that dragged down Japan’s economy for a decade.

How much bad debt is out there?

First, there’s the official figure: China’s 10 largest banks reported $94 billion in overdue loans at the end of 2013, an amount that technically includes every loan on banks’ books that is late, even if just by a day.

But these figures are taken with a huge grain of salt, say experts both inside and outside China. The country’s banks routinely assign new deadlines to overdue debt—called “rolling over” loans—or offload it from their books to keep their late loan ratios artificially low, analysts say. And that figure doesn’t include the country’s massive “shadow banking” system of unreported lending, which some believe could rival the size of the official bank network.

Oxford Economics estimates China’s total bad debt is 100 times the official amount, or between $1 trillion and $1.9 trillion. Goldman Sachs analysts went even farther last year, estimating that China’s total credit losses in the bank and non-bank system could equal $3 trillion—a figure that they still believe is accurate, the bank told Quartz recently. Operating losses at industrial companies increased 13.2% from March 2013 to 2014, Goldman said in the bank’s latest report on China’s banks, after falling for all of 2013—a sign that even more bad debt could be headed banks’ way.

What that means is there’s plenty of work for the US-born industry of restructuring and workouts, a business that thrives when times are tough. “The scale of the potential market for restructuring services is just mind-boggling,” Edward Middleton, the head of restructuring services at KPMG China, told Quartz. “We know of institutions that say to us ‘We have 100 or more distressed situations that we need to resolve.’”

Whose debt is going bad?

With such huge figures being thrown about you’d think China would be awash in reports of defaults and bankruptcies. But that has not been the case so far. China’s shadow banking system keeps funneling money to insolvent companies, and outright bankruptcies remain exceedingly rare.

“There’s a tremendous amount of activity below the surface,” said Blount. China’s companies have been holding “distressed investment fire sales” to get troubled loans off their books, he said. Here’s a few troubled situations that have been made public:

  • Chinese coal company Liansheng Group said it would not be able to pay back some $5 billion in debt last year. The entire industry is troubled—a dozen coal mining companies have debt-to-equity ratios of over 100%, and some are due to run out of cash, Bloomberg reported this month.
  • Suntech Power Holding is one of a handful of solar companies that has said it can not pay back its debts. Hundreds of others, bloated on government handouts, have scaled back their business after prices for solar cells plummeted . The industry’s top players had nearly $30 billion in liabilities last year.
  • Huatong Road & Bridge Group, a private construction company, said this month it may default on a $64.4 million bond.

Completely different industries are looking troubled as well. The top three distressed industries in Greater China are real estate, automotive manufacturing and pharmaceuticals, according to a recent survey by AlixPartners.

What are China’s banks and government officials doing about it?

They’re cleaning house, but very quietly. The turning point seems to have been Nov. 2013, after China’s Communist Party third plenum. The underlying theme of that agenda-setting meeting was that the government would give markets a greater role in determining the price of capital.

Since then, says KPMG’s Middleton, “we’ve seen a complete step change in attitude” from government officials towards dealing with distressed companies. Everyone is “fully on board” with Xi Jinping’s pledge to reform China’s state-owned enterprises, he said, and KPMG is involved in discussions with officials about what that restructuring should look like—something that hasn’t happened before. At the same time, in the bank sector “there’s a renewed urgency” to dispose of non-performing loan portfolios, Middleton said. “We are now acting for a clutch of financial institutions across the country who are anxious to dispose of” these portfolios.

During the last bad-debt watershed, China’s big banks sold these off, mostly to four government-created asset managers. This time, however, China’s banks say they want to hold on to the debts, so they don’t give away potential profits.

Will foreign companies make money off this new flurry of bad debts?

“The problem is that there isn’t that much ‘turnaround’ business in China,” in the way that it works in the US, said Robert Fonow, founder of consultancy RGI and a veteran turnaround expert based in China. Allowing companies and management to publicly fail is a politically and culturally sensitive decision.

There’s no culture of “asking someone to come in and help” with a massive overhaul of a company, Fonow said, and even with the mountain of bad loans, there’s a reluctance to bring in foreign companies for this kind of help. Making things worse, “I think everyone finds it difficult to get Chinese companies to pay for this kind of service,” said Fornow.

Nonetheless, the restructuring business in China is so competitive right now that McKinsey and AlixPartners, the bankruptcy adviser founded in Detroit in 1981, are locked in a legal battle over several Alix employees who defected to McKinsey, taking with them, Alix claims, trade secrets about clients. Last month Alix hired Chinese experts in manufacturing, shipping and logistics to deal with what CEO Fred Crawford called “increasing demand” in the region.