(Bloomberg) — The numbers circulating through official Beijing were even worse than feared.
This looked like one of the biggest single money losers in modern Chinese history. But who would be willing to clean up the mess at China Huarong Asset Management Co., the country’s shaky “bad bank”?
The long-delayed financial results – unknown to the rest of the world at the time – reached Chinese office in mid-July. The numbers were so dire that regulators were hesitant to sign them. They feared that any association with Huarong would hurt their careers.
The Ministry of Finance, which has controlled Huarong since its inception, was eager to hand over the keys quickly. Part of China’s sovereign wealth fund considered making a play, but then, after reading the books, first wanted money from the powerful People’s Bank of China. The idea was shot.
Finally, eyes turned to another rich and powerful state-owned enterprise, Citic Group — and the people there began to sweat. They feared that they would be the ones to blame if things went wrong.
Despite everything, it seems that Huarong will be saved. Beijing isn’t ready to see a state-owned company as large and connected as this go down — to see Huarong essentially become a Lehman Brothers of China. After months of turmoil, things are settled for now: Huarong is getting financial support from Citic and several other state-backed companies. A potentially catastrophic default has been averted. Bondholders breathe out. Shareholders look like they’ve been hung out to dry. The inside story of China’s too-big-to-fail moment reaches into the highest levels of the country’s financial power structure. It snakes through the ministries and regulators where technocrats are already working to solve other, bigger problems in the country’s debt-ridden financial system. Officials have to walk a fine line. Until Huarong was in debt, few questioned whether Beijing would stand behind the largest state-owned enterprises should disaster strike.
Now, after an era of corporate surpluses, President Xi Jinping is stepping in. He wants to curb intoxicating loans — much of it made possible by creditors’ rock-solid assumptions that state-owned companies are too big to fail — without risking a full-blown crisis.
This report has been compiled from interviews with people in various parts of the Chinese government. Given the stakes, they spoke on the condition that they were not named.
Huarong’s rescue, announced on August 18, was the culmination of months of bureaucratic infighting, ego-flexion and money-making. Central to this is the question that investors have been asking themselves all along, and which many still ask: who is – and who is not – too big to fail in China? Huarong was rescued. Other less well-connected companies may not be so lucky. Of particular note is real estate giant China Evergrande Group, now arguably the country’s biggest financial concern.
Sergey Dergachev, senior portfolio manager at Union Investment in Frankfurt, says global investors can no longer be sure that every major corporation or state-owned company will be bailed out in no time. “This assumption is no longer valid,” said Dergachev, who has invested in Huarong. Bond investors, he adds, will have to stay on their toes.
For years, China let companies like Huarong and Evergrande borrow heavily to expand. Now Xi has alarmed foreign investors by redefining the relationship between the state and private business and by curbing China’s internet giants and other industries. The crackdown erased more than $1 trillion in shareholder value.
Huarong was founded after the Asian financial crisis of the 1990s to help protect Chinese banks. The idea was to have the bad bank clean up the soured loans granted to many state-owned companies.
Then the longtime chairman, Lai Xiaomin, started to borrow heavily to expand into all kinds of businesses. Known as the God of Wealth, Lai was later swept up in a corruption scandal and executed last January, just as Huarong’s troubles were gaining attention in the financial world.
In June, no one was under any illusions: Huarong needed help. But workers at the company’s Beijing headquarters were shocked at the mere suggestion that the once-powerful Huarong might become a subsidiary of another state-owned company. Huarong’s decades-long ties to the Treasury Department were a testament to status and prestige — suggesting a level of government support that would have meant cheap borrowing costs in better times. Huarong’s executives were counting on some sort of government aid, but never dreamed that their prized link with the finance ministry would be severed, according to people familiar with the case.
And yet, driven by individual interests, several regulators could not agree on who should take responsibility for Huarong — or, more importantly, who should pay for it, according to acquaintances. Numbers of offshore subsidiaries and onshore units were counted over and over. It was clear that Huarong had neither the time nor the money to save himself.
Central Huijin Investment Ltd., a branch of China’s sovereign wealth fund, began to kick the tires. But it hoped the central bank would provide a loan to fund a deal. The proposal was promptly rejected.
At the end of June, regulators moved into Citic. The conglomerate is a ministerial-level financial power under the direct supervision of the Chinese cabinet, with more than $1 trillion in assets.
For nearly two months, a Citic team pored over the books at Huarong headquarters. Even at Citic, a Chinese company as connected as they come, the political nature of the job raised eyebrows. Huarong’s finances were so troubled and past transactions were so fraught that some members of the Citic team feared being blamed for the mess. They wanted assurances that they would not be held accountable if higher circles later discussed a rescue plan, one of the people said.
The numbers, verified by Ernst & Young, were shocking. Huarong had lost 102.9 billion yuan ($15.9 billion) in 2020, more than its combined gains since its IPO in 2015. It has written off 107.8 billion yuan in bad investments. For two weeks, officials resisted signing the results out of concern for their own careers. But the clock was ticking: Huarong had to announce the results, which were already months late, at the end of August, otherwise it would be considered technically negligent. The deadline was just weeks away.
The terms were finally drawn up and the State Council, long silent on Huarong, gave its blessing to a bailout that combines a government bailout with a more market-driven recapitalization. Huarong will receive about 50 billion yuan of fresh capital from a group of investors led by Citic, which will take over the majority stake from the Ministry of Finance, famous people have said. Huarong is expected to raise 50 billion yuan more by selling non-core assets. On August 18, Huarong went public with his massive losses and soon got news of his rescue.
Bondholders cheered. For the brave, Huarong could have been the trade of a lifetime: Some of the perpetual bonds have risen to 97 cents from a low of 50 cents in May.
Aside from the exuberance of the market, many remain divided on the outlook from here on out. Following the news of the bailout, Moody’s Investors Service downgraded Huarong’s credit rating by two notches to Baa2, just above junk grade, and warned that further downgrades may follow. Fitch Ratings, meanwhile, has revised its outlook from negative to positive. S&P Global is still considering a downgrade.
Equity investors are licking their wounds. Warburg Pincus was among a group of strategic investors who bought a $2.4 billion stake in Huarong before it went public in 2015, paying 2.12 yuan per share. Huarong’s shares traded at HK$1.02, or the equivalent of 0.85 yuan, before being suspended in April. That equates to less than 0.3 times the book value at the end of June 2020.
The China Banking and Insurance Regulatory Commission and Huarong did not respond to requests for comment. Citic and Warburg Pincus declined to comment.
Wu Qiong, Head of Fixed Income Research at BOC International Holdings Ltd. in Hong Kong, says few Chinese companies are as politically connected as Huarong, even a sprawling developer like Evergrande. “The government doesn’t have a strong incentive to save it, at least not directly involved in this way,” she says.
For David Loevinger, a former senior coordinator for China affairs at the US Treasury Department, the takeaway is much the same. Everyone used to believe that Huarong was too big to fail. “Now you can’t say that with 100% certainty,” he says. His advice to investors: choose wisely.
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