China Investment Trust’s Woes Could Signal a Shakeout

For Don Dempsey, president of China development for burger titan McDonald’s, the recent bankruptcy of the giant Guangdong International Trust & Investment Corp. poses little threat to the firm’s rapid expansion in China, where it currently has 220 outlets.

McDonald’s had a joint venture partnership with the Guangdong investment trust, or Gitic, to operate 37 restaurants in the prosperous southern province bordering Hong Kong. But it also has other suitors in the province ready to take Gitic’s place.”The stores are still operating and serving,” Dempsey said. “Our joint venture contract gives us clear right to purchase in the event of a bankruptcy so we will probably end up with another Chinese partner.”

McDonald’s’ experience illustrates the valuable--as well as the ultimately unreliable--role that China’s so-called “itic” investment trusts have played as a link between the government and the hundreds of foreign companies and banks eager to exploit China’s future.

McDonald’s has a way out. But for about 130 foreign banks, including Citibank and Bank of America, that have lent an estimated $12 billion to Gitic and 240 other similar state-owned itics scattered across China, the bankruptcy announced in January is more worrisome.

The bankers have the uneasy feeling, as one Western banker put it, “that the rules have changed in the middle of the game.”

“For most of the banks and investors,” the banker, who asked not to be named, said in a telephone interview, “the amount of money they have tied up in Gitic is not enough to sink them. The much bigger issue here is the knock-on effect. Does this mean that the government’s past policy and practice of supporting its financial institutions is finished?”

For the moment, capital has become harder to get, analysts say.

According to Anthony Lok, banking research director at Nomura International in Hong Kong, the short-term impact of the Gitic bankruptcy has been a “contraction of liquidity as foreign bankers either reduce or pull out to a certain extent, especially in southern China.”

The impact will become clearer in coming months as more of the itics--they represent 3.5% of China’s financial sector--face possible liquidation under the country’s new bankruptcy laws.Longer term, most analysts view the Gitic bankruptcy as positive.

“We see this as the first step in cleaning China’s banking system,” wrote CS First Boston analysts Dong Tao and Joseph Lau.

Yet the specter of more bankruptcies by these local and provincial trusts throws into question a basic principle of doing business in China. Since China began opening to foreign investment nearly two decades ago, the conventional wisdom has been that successful business depends mostly on personal connections and the implicit backing of the all-powerful state.

China’s system of investment trusts was created in the early 1980s as a way of attracting foreign capital, primarily for infrastructure projects. But, encouraged by foreign investors rabid to enter the tantalizingly large China market, the “itics” multiplied until even the smallest provincial capitals had one or more.

At one point a few years ago, before the central government began to rein them in, there were more than 700 such trusts across China.

The largest and best known is the central government’s China International Trust & Investment Corp., or Citic, which claims more than $23 billion in assets and 40 subsidiaries with substantial investments in telecommunications, trading, Hong Kong property and infrastructure. Citic, which is affiliated with the State Council in Beijing, is not likely to be touched by latest reforms.

“Basically,” said analyst Lachlan Christie of South China Brokerage Ltd., “the quality of Citic is not comparable to the rest.”

But most of the others, ranging from minuscule trusts in Inner Mongolia to more substantial ones in the Yangtze River valley, are expected to be closed, consolidated or left to go bankrupt under the government reform scheme.

By allowing Gitic to declare bankruptcy, China was sending a message to foreign lenders and their Chinese partners that the old networking system based on personal assurances is no longer certain.

In case the international community needed any clarification on this point, it got it when a senior official of Guangdong, China’s richest province, met with diplomats from 16 countries in the provincial capital Guangzhou on Feb. 13.

The era of “window companies” established by local governments to attract foreign capital, Guangdong Vice Gov. Wang Qishan told the diplomats, should now be considered closed. Wang, a close political ally of China’s reform-minded Premier Zhu Rongji, then blamed foreign bankers for contributing to the problem of nonperforming Chinese companies.

“In recent years,” Wang said, “many overseas financial institutions did not follow accepted international practices in evaluating Chinese companies and projects in giving loans to them. They bet their stake on guarantees, promises, and letters of support from the local government . . . some even confused these promises for sovereign debt.”

Despite clear warnings for months that it was coming, the Gitic bankruptcy caught many disbelieving foreign bankers--primarily from Japan and Europe--by surprise. The trust listed $4.3 billion in liabilities against only $2.7 billion in assets. About half of the debt was listed as loans from foreign banks.

Some overseas bankers immediately cried foul, particularly after the Chinese government announced that foreign creditors would not be given priority treatment during the liquidation.

“There were some people who wrongly believed that there was some kind of implicit government guarantee of one form or another on loans,” said Lok, “In emerging markets there is often this notion that the state is a guarantor. But the fact is that there was never any legal binding guarantee.”

But one Western banker embroiled in the Gitic episode argued that the state guarantees, although not legally binding, were very clear.

“This was a government company, wholly owned and controlled by the provincial government. All of the management was appointed by the government. Assurances of support from these officials were coming directly from the state,” said the banker. “The clear government policy up until Gitic was to support government-owned financial institutions.”

More bad news may be in store for banks that lent money to other investment trusts similar to Gitic. Late last month, a senior official in Guangzhou announced that another large trust, the Guangzhou International Trust & Investment Corp., or Gzitic, with $2.3 billion in liabilities, also faced possible liquidation under China’s new bankruptcy laws. Guangzhou Vice Mayor Shen Bainian said an announcement on Gzitic’s fate will be made in March after its assets are evaluated.

Abuses and corruption under the system of investment trusts are widespread.

Foreign bankers and investors, for example, were never sure where their money went despite audits dutifully produced by the trust management. Many cases were reported of trust officials, often local Communist Party cadres unschooled in economics, borrowing money from eager foreign banks and reinvesting the funds in the stock market. After the Gitic bankruptcy was announced, it was revealed that the company had 103 subsidiaries not even listed in the annual report.

“Year after year we were told that Gitic was making money and that its assets exceeded its liabilities,” said one Western banker. “But at the creditors meeting in January, we were told that Gitic had been losing money since 1992 and that its liabilities substantially exceeded its assets.”

Collectively, the 240 itic trusts have assets of $48 billion and $11.9 billion in foreign debt, according to a recent report by the Hong Kong office of Credit Suisse First Boston.

At the end of the reforms, predicted Lok, “the plan is to get the 240 itics down to about 40 or so.”