January 22, 1999

Bankruptcy the Chinese Way: Foreign Bankers Are Shown to the End of the Line

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By MARK LANDLER

UANGZHOU, China -- People boarding the Sunday morning train from Hong Kong to this southern Chinese city on Jan. 10 were treated to a novel sight: Dozens of Western bankers in suits sat among the Chinese travelers, their briefcases stashed between lumpy bags of food and clothing.

The pin-striped passengers were in a chatty mood. They were about to learn the fate of one of China's largest state-owned companies, Guangdong International Trust and Investment Corp., or Gitic. Though Gitic was in danger of defaulting on nearly $1.5 billion in loans and guarantees from the foreigners' banks, few of the creditors believed they would be left in the lurch.

Three hours later, they rode the train back to Hong Kong in stunned silence. In a curt, 90-minute meeting, Chinese officials told the creditors that they planned to throw Gitic into bankruptcy. Bankers who inquired about when they might be repaid got a blunt response: Take a number and get in line.

China's decision is more than a slap in the face to the banks. It is a frontal assault on the way business has been conducted in the world's most populous country. By refusing to bail out Gitic, China is signaling that investors will be held accountable for their lending. Gone are the days when foreign bankers could rely on political connections as a substitute for proper credit-risk analysis.

"People went up there with higher expectations," said T.K. Chang, an expert in Chinese bankruptcy law in the Hong Kong office of Coudert Brothers, who attended the meeting as a representative of South Korean banks. "Nobody expected that it would be put into bankruptcy."

And why should they? China has rarely used its bankruptcy law, although it has been on the books since 1986. And it has never invoked the law in the case of a major state-owned enterprise -- let alone one with foreign creditors like Citigroup, Merrill Lynch, HSBC, and Sumitomo Trust and Banking.

But all that is changing. Beijing's decision to crack down on profligate borrowing, China watchers say, reflects a broader crusade by Prime Minister Zhu Rongji to make China's corporate sector more rational and its economy more efficient. Although China is growing faster than its Asian neighbors, it shares many of their frailties -- including a wobbly banking system and bloated state companies.

The Gitic bankruptcy will be a litmus test of Beijing's resolve, according to lawyers and bankers. Before it can reap the benefits of more disciplined business practices, the central government must first show that it can impose an untested bankruptcy law on its often unruly provinces.

"This bankruptcy will set the pattern for future insolvencies, and there will be hundreds of them, if not thousands," said Gordon Chang, a bankruptcy lawyer in the Shanghai office of Paul, Weiss, Rifkind, Wharton & Garrison.

Gitic, which is based in this provincial capital, functioned as the main fund-raising arm of the Guangdong government. Though a separate company, Gitic is controlled by the provincial authorities, who have often enlisted it to help finance projects, like the toll highway that connects Hong Kong to Guangzhou.

Over the last decade, Gitic borrowed billions of dollars -- mostly in foreign currency and not approved by Beijing -- to pay for a pell-mell expansion into real estate, hotels, securities trading, even silk manufacturing. Gitic's distinctive orange logo sits atop dozens of apartment blocks in this clamorous city, while its 63-floor headquarters was until recently Guangzhou's tallest tower.

The trouble is, most of Gitic's businesses lose money, and the company capsized under $4.3 billion in debt. When skittish Japanese and Korean banks called in their loans last fall, Gitic could not pay. The Guangdong government cobbled together funds to keep it afloat. But Beijing, eager to rein in the maverick province, shot down the plan. On Oct. 6, the central government abruptly shut down Gitic and appointed the People's Bank of China to start liquidating it.

"This company was basically squandering state resources," said Lawrence Lau, the director of the Center for Economic Policy Research at Stanford University. "The province wasn't supposed to guarantee its loans, but it did. And the Western banks were colluding with these guys."

Lau and other China experts praised Beijing's hard line, which they said would help it tackle the far more daunting challenge of cleaning up China's debt-ridden banks. "The discussion in Beijing is: 'If we bail out Gitic, will it encourage more behavior like this?"' Lau said.

The bankers, however, insist they made loans to Gitic in good faith -- not as part of a collusive deal with provincial leaders. Many regard Beijing's action as less a courageous stand than a craven betrayal.

"China's credibility could be badly damaged by how this was handled," said Brian Lippey, the managing director of Tokai Bank Ltd., a Japanese bank with modest exposure to Gitic. "I'm not saying the government should bail out every company, but the process has to be in accordance with international norms."

A leading Hong Kong banker was even blunter. "This will have repercussions for years," he said, speaking on the condition of anonymity. "It will be a few years before people lend again, because they have deep wounds."

Whether that is true or not, the bankers are especially raw because they believe they had guarantees from provincial officials that either Guangzhou or Beijing would stand behind their loans if Gitic went sour. Sometimes these guarantees came in the form of handshakes; other times they were set out in "letters of comfort."

"More than 60 bankers said they were told that the government would pick up the tab if things went wrong," the Hong Kong banker said.

In the aftermath of Gitic's collapse, banks have begun calling in loans to other troubled Chinese companies. As they do, more Chinese companies are defaulting. Dalian International Trust and Investment Corp., the fund-raising arm of the northern city of Dalian, recently acknowledged that it had missed payments on foreign loans. Other investment-trust companies affiliated with Guangdong, Fujian, and Hubei provinces have also missed payments.

For now, the debt crisis is mainly limited to investment trusts. These financial institutions, known as ITICs by investors, sprouted like weeds after Deng Xiaoping opened China's economy in 1978. Their purpose was to raise money from outside China for the provinces. But with their loose management and shaky finances, they became the Chinese equivalent of the U.S. savings and loan debacle.

Last week Beijing said it planned to prune the number of investment trusts to 40 from 240. That will mean shutting down or merging scores of ITICs, most of which owe money to foreign banks. Basisfield, a research firm that tracks corporate debt issues, estimates that the investment trusts have $5.1 billion in total debt -- $1.5 billion of it in direct loans from foreign banks.

But now many experts fear the debt crisis is spreading beyond investment trusts. Guangdong Enterprises Holdings, another prominent Chinese company, has suspended payments on $2.9 billion in debt, while it overhauls its operations with the help of Goldman, Sachs.

Guangdong Enterprises is a "red chip" -- a Hong Kong-based company controlled from the mainland, in this case by the Guangdong government. Formed in 1980, it was one of the first companies set up by provincial regimes to tap overseas markets. Like Gitic, it has diverse holdings in trading, property and hotels. Unlike Gitic, some of its assets would seem to be sure-fire winners.

Its Hong Kong subsidiary, for example, is one of the largest importers of fresh food from China to Hong Kong. Yet that unit recently disclosed that it had $391 million in debt and a cash balance of only $13.7 million.

At the prodding of Goldman, Sachs, Guangdong Enterprises has owned up to its failings. In a report to creditors on Jan. 12, it said its woes were the result of "poor business decisions historically which have resulted in poor or nonperforming assets and an overall lack of strategic business focus."

Before the Asian economic crisis, red chips were the rocket fuel that propelled the Hong Kong stock market. Now they are in disrepute. In a report for investors last November, before it was hired to fix Guangdong Enterprises, Goldman estimated that the red chips were groaning under nearly $13 billion in debt.

"Bankers are no longer making distinctions between red chips and other Chinese companies," the Hong Kong banker said.

Analysts said China would hardly wither if foreign banks turned off their taps. Foreign lending accounts for a relatively small part of the overall economy, and analysts said the country's four main domestic banks could pick up much of the slack. Although China has more than $130 billion in foreign debt, it can draw on vast household savings to finance public spending.

Still, lawyers are poring over China's bankruptcy law for clues about how it will handle future insolvencies. While the statute borrows some elements of the U.S. bankruptcy code, it is vague about key concepts -- not least the notion of reorganizing a company, rather than simply liquidating it.

The law also offers little guidance about which creditors should get priority in the repayment process. It says only that employee wages, taxes, and legal costs must be paid before creditors are reimbursed.

Lawyers said the Chinese government had already made decisions that went beyond the statute. To forestall social unrest, it has decided to bail out 25,000 people who had deposited money in Gitic's banking unit. It has also declared that creditors whose loans were registered with Beijing would receive priority over creditors whose loans were made without its approval.

Legal precedents will be of little help to creditors because the law has been so seldom used. Before Gitic, the largest bankruptcy case in Chinese history was that of a sugar mill in the northern province of Heilongjiang that foundered last November with less than $100 million in debt. With so much more money involved here, lawyers said the banks would push the court to impose the law scrupulously.

"Although the bankruptcy law is faulty in the extreme, we're going to see a lot of improvement very quickly," said Chang of Paul Weiss.

China has plenty of motivation to stick to the rules. If the court's conduct of the Gitic bankruptcy passes muster with foreign creditors, experts predict that foreign banks will resume lending to Chinese companies -- if a good deal more prudently than in the past.

"Like most things with China, this is neither all good nor all bad," said Richard Margolis, a former British diplomat in Beijing who is now a strategist for Merrill Lynch in Hong Kong. "If you're a creditor, dealing with the nitty-gritty of the bankruptcy, this is an unmitigated disaster. On the other hand, this is a much needed and overdue tidying up of China's books."