This series of articles focusses on the sectors of Chinese debt markets that are in the process of opening up to foreign investors. In this article, we will touch on the state of the PRC real estate financing market, before delving into policy developments supporting the market-oriented disposal of Non-performing Loans ("NPLs").
This article provides foreign investors and financiers with a guide to China's NPL market, focusing on the China's NPL market practice, players and legal and regulatory landscape. It is the next in our series of articles following on from our article published on 20 October last year entitled: "Chinese real estate financing: onshore/offshore financing structures".
Part I: Background on China's NPL market
1. Macroeconomic context
China classifies loans into five risk-based categories: normal, special-mention, substandard, doubtful and loss, with loans falling within the bottom three categories being referred to as NPLs. According to the CBIRC, as at the fourth quarter of last year, Chinese banks held around RMB 2.7 trillion of NPLs (resulting in an NPL ratio of 1.84%), and RMB 3.80 trillion of special-mention loans, which are one notch above NPLs in China's risk-based classification.
Given uncertainties currently surrounding the regional and global economy, the trend of rising NPL levels is expected to continue in 2021.
In the real estate sector, the trends we described in our article last year have continued into this year. Owen Gallimore, head of credit strategy at ANZ told the Wall Street Journal in January:
"About [US]$34 billion of Chinese corporate bonds in dollars were yielding more than 15% as of Thursday, including $25.5 billion of property debt".
At those yield levels, he noted, conventional refinancing becomes difficult, meaning that distressed asset disposal, or distressed debt disposal, becomes more likely.
The concerns of the offshore bond market have started to come into fruition. For instance, it has been widely reported that a major industrial park developer with billions of offshore bonds defaulted on a maturing bond at the end of February.
Most of the debt reported on in the foreign press relates to debt held by foreign investors, meaning the regulatory regime applicable to the NPL market will not apply. However, the underlying fundamentals of the real estate sector will equally apply to real estate debt held by Chinese financiers.
It is this debt (Chinese NPLs, originally held onshore China) that is the focus of the remainder of our article.
From our perspective, whilst, there are many policy reasons why regulators are increasing foreign participation in the Chinese NPL market (e.g. the deleveraging and de-risking of Chinese banks and other financial players and the use of offshore expertise and resources in crafting solutions to distressed scenarios), we do not expect there will be an "opening of the floodgates".
That is because the objective of ensuring financial stability in China will continue to be Chinese regulators' paramount policy consideration. Accordingly, we can expect China to continue to adopt a gradual and incremental approach to reforming and opening up its NPL market and require strict compliance with regulatory requirements in order to prevent systemic risks.
2. Key players in China's NPL market
For now, the Chinese NPL market continues to be dominated by the state-owned national AMCs.
The traditional four national AMCs were established in 1999 with a mandate to purchase NPLs from the big four state-owned Chinese commercial banks and to manage and dispose of these NPLs. With the development of the Chinese NPL market, the business models of the traditional four national AMCs were required to become more diversified The traditional four national AMCs and their original corresponding commercial banks were as follows:
- China Cinda Asset Management Co., Ltd. – China Construction Bank
- China Great Wall Asset Management Co., Ltd. – Agricultural Bank of China
- China Huarong Asset Management Co., Ltd. – Industrial and Commercial Bank of China
- China Orient Asset Management Co., Ltd. – Bank of China
On 11 December 2020, the China Banking and Insurance Regulatory Commission (CBIRC) announced its approval for opening up of the fifths national AMC China Galaxy Asset Management Co., Ltd. 中国银河资产管理有限责任公司 (China Galaxy AMC), which was converted from Beijing-based Jiantou Citic Asset Management Co., Ltd 建投中信资产管理有限责任公司. In contrast to the traditional four national AMCs, China Galaxy AMC's background in the securities sector and the fact that its minority shareholder is one of China's leading securities firms could mean that China Galaxy may end up focusing on non-performing assets arising from capital markets and securities activities, including onshore bonds in the real estate sector.
The Administration Measures on Bulk-transfer of NPLs by Financial Enterprises (Cai Jin  No.6) issued by the Ministry of Finance (MOF) and the then China Banking Regulatory Commission (CBRC) on January 18, 2012 (2012 Measures) established the regulatory framework for Chinese banks and other financial institutions to transfer NPLs to national AMCs on a "bulk" basis (presently defined as transferring three or more NPLs). For the purposes of this article, the term "NPL portfolio" refers to a portfolio of three or more NPLs such that the transfer of an NPL portfolio necessarily involves a bulk transfer for Chinese regulatory purposes.
The 2012 Measures also allowed provinces in China to establish local AMCs that can acquire NPL portfolios directly from financial institutions in their home province. In 2016, regulations governing local AMCs were relaxed by the then CBRC and local AMCs are now generally allowed to transfer NPLs they have acquired to entities outside their home province.
On 7 January 2021, CBIRC promulgated the Circular of the General Office of the CBIRC on the Pilot Work of NPL transfers. This circular allows the transfer by pilot commercial banks to the national AMCs, some qualified local AMCs and financial asset investment companies of (i) NPLs generated from corporate loans on a non-bulk basis, and (ii) NPLs generated from individual loans on a bulk basis (provided that such NPLs cannot be further transferred). This widens the channel in which the commercial banks can dispose of their NPLs and ultimately allows more entities to participate in the primary market of NPLs.
Over 60 local AMCs have been approved to date and we expect more approvals in the future. In some provinces, local AMCs play an increasingly important role in acquiring NPLs from local commercial banks.
3. Transactions in China's NPL market are divided into Primary Market Transactions and Secondary Market Transactions
Generally, only AMCs and financial asset investment companies are allowed to purchase NPLs on a bulk basis or a non-bulk basis (as the case may be) from Chinese banks. The acquisition of NPLs directly from Chinese banks and other Chinese financial institutions is referred to as the Primary Market Transaction.
The acquisition of NPL portfolios from AMCs by investors (both domestic and foreign) and subsequent transfers of NPL portfolios among investors are referred to as Secondary Market Transactions.
4. Channels for foreign investors to participate in China's NPL market
Over the past few years, new channels for foreign investors to access China's NPL market have emerged and existing channels are becoming more streamlined and investor-friendly.
The key existing access channels are summarised below.
a. Purchasing NPL portfolios from AMCs
National AMCs: As has been the case since 2001, foreign investors can purchase NPL portfolios from national AMCs through a competitive bidding process. This is a well-established channel for foreign investors' participation in the Chinese NPL market. Foreign investor participation through this channel continues to require Chinese regulatory approvals for each acquisition, but over the years, the process for obtaining Chinese regulatory approval in connection with a national AMC's transfer of NPLs to foreign investors has become simplified and more streamlined.
Local AMCs: There remains uncertainty regarding whether foreign investors can purchase NPL portfolios from local AMCs. The relevant regulations are not clear on this point.
b. Purchasing NPLs from Chinese commercial banks (including pursuant to the Shenzhen NPL Pilot Program)
As noted, generally speaking, foreign investors cannot purchase NPLs directly from Chinese commercial banks. However, foreign investors can engage with AMCs and the AMCs can help source NPL portfolios from Chinese commercial banks. In these types of arrangements, the AMC would essentially act as a conduit that first acquires an NPL portfolio from Chinese commercial banks, and then on-sells the NPL portfolio to foreign investors via a competitive process or, alternatively, issue NPL-asset-backed securities ( as further described below).
In 2017, a cross-border NPL pilot program (Shenzhen NPL Pilot Program) was set up by China's foreign exchange regulator, the State Administration of Foreign Exchange (SAFE). In essence, the Shenzhen NPL Pilot Program allows foreign investors to directly purchase NPLs on a non-bulk basis from Chinese banks and branches in Shenzhen. The pilot program also allows foreign investors to purchase NPLs on a bulk basis from AMCs that list NPL portfolios on the Qianhai Financial Assets Exchange (QEX) and other local exchanges. Similar pilot programs have begun in other Chinese cities and provinces.
c. Investing in NPL securitizations
In 2016, Chinese regulators established a pilot program for qualifying financial institutions to restart the NPL ABS market in China. So far, a dozen Chinese commercial banks have issued NPL asset-backed securities (ABS) in China's institutional bond market, the China Interbank Bond Market (CIBM). In November 2019, the Chinese regulators further expanded the list of Chinese financial institutions that are eligible to participate in the NPL ABS pilot program.
Qualifying foreign institutional investors can invest in these NPL ABS via established channels such as the Qualified Foreign Institutional Investor (QFII) and RMB Qualified Foreign Institutional Investor (RQFII) schemes, the CIBM Direct Access Scheme and Bond Connect.
d. Entering into joint ventures with national AMCs
Foreign investors can also enter into joint ventures with national AMCs for the purpose of acquiring and managing NPL portfolios.
e. Using QFLP / RQFLP structures
Some foreign investors have relied on the Qualified Foreign Limited Partner (QFLP) or RMB Qualified Foreign Limited Partner (RQFLP) pilot programs established in certain Chinese cities to form private equity funds that invest in NPL portfolios. The features of each QFLP / RQFLP pilot program are different, resulting in different regulatory requirements and procedures associated with pursuing this access channel, depending on the particular pilot program on which a foreign investor is seeking to rely.
f. Establishing wholly foreign-owned "non-licensed" AMCs
Foreign investors have successfully established wholly foreign-owned AMCs in China. Over the last 3-4 years, relevant authorities in Beijing, Shanghai and Tianjin have encouraged foreign asset managers to invest in the PRC NPL market and have approved the establishment of so-called wholly foreign-owned AMCs on a case-by-case basis. However, we note that most of these wholly foreign-owned AMCs are not permitted to participate in Primary Market Transactions (i.e. they cannot purchase NPL portfolios directly from Chinese banks and financial institutions) but are permitted to participate in Secondary Market Transactions (i.e. they can purchase NPL portfolios from AMCs) without the need for further approvals for each acquisition.
Wholly foreign-owned AMCs that can only participate in the secondary market are commonly referred to as "non-licensed" AMCs.
g. Establishing foreign invested AMCs under Article 4.5(2) of the China-U.S. Phase One Trade Deal
The China-U.S. Phase One Trade Deal (formal title: Economic and Trade Agreement between the Government of the United States of America and the Government of the People's Republic of China) includes a commitment by China to further open up its NPL market to U.S. firms. Specifically, under Article 4.5(2) of the Phase One Trade Deal, China has agreed to allow U.S. financial services firms to apply for local (and eventually national) AMC licenses, which would allow them to acquire NPL portfolios directly from Chinese banks. More specifically, Article 4.5(2) provides that, if and when China opens up its national AMC market to domestic firms, U.S. financial services firms may be granted national AMC licenses on the same basis as their Chinese counterparts, and participate in the national NPL market on the same footing.
Article 4.5(2) itself does not contain much detail. Over time, it is hoped that relevant Chinese regulators will publish policies and guidelines to clarify the eligibility criteria, requirements, procedure and timeline for U.S. financial services firms to obtain local (and eventually national) AMC licenses as well as the scope of permitted business activities for these foreign-owned AMCs. For example, market participants will want to know if foreign-owned AMCs can engage in precisely the same activities as domestic AMCs. In this respect, we note that the existing CBIRC rules on the establishment and business scope of non-bank financial institutions do not shed light on this question. To the extent that Chinese-owned AMCs are permitted to engage in a broader range of activities in the future, foreign-owned AMCs may also benefit from such regulatory relaxation.
These policies and guidelines may come from either the relevant provincial governments (in the case of local AMCs) or the CBIRC, which is the main regulator overseeing China's banking sector and financial institution NPL market.
Part II: Looking ahead over the remainder of 2021
It seems likely that there will be a need for either distressed property sales, or sales of distressed property debt in the remainder of 2021. As such, it does seem likely to us that there will be an increase in foreign participation in the Chinese real estate NPL sector. However, as we've noted, the increases are expected to be incremental, and regulators will be keeping a very close eye on the maintenance of financial stability.
 "Chinese Property Developers Have Huge Debts to Refinance", The Wall Street Journal, 16 January 2021.
 Financial asset investment companies are non-banking financial institutions established by commercial banks as the major shareholder and engaging in, amongst other things, acquiring corporate distressed debt for the purposes of debt-to-equity swap.
 Under 2012 Measures, the transfer of NPLs generated from individual loans is prohibited.