When Huarong Asset Management employees arrived at their Hong Kong headquarters on April 18, they found it had undergone a radical transformation. The walls of the company’s offices, which had been covered with images of the chairman Lai Xiaomin , now stood bare. Stacks of glossy books authored by Mr Lai had vanished. It was as if he had never existed, says one employee present that day.
Staff at the subsidiary of the powerful Beijing-based debt manager would soon learn that Mr Lai had been detained in a corruption probe, the latest executive to fall foul of the government. But what was not clear at the time was that Huarong was at the centre of a crackdown on corruption in the financial sector and, in particular, excessive corporate leverage. It is a campaign that has spilled across China’s borders and into global markets.
The curbs on the investment banking operations at Huarong and three other state-owned asset management companies, or AMCs, slammed the brakes on easy access to credit for some of China’s most aggressive buyers of overseas assets. The move led to defaults and fewer foreign acquisitions by Chinese companies.
The country’s top financial regulators last year launched a campaign to stop corporations from moving vast quantities of capital offshore — at its peak in 2016 $220bn was channelled out in foreign direct investment. But simultaneously the AMCs were operating aggressive investment banking businesses and facilitating the rise of offshore finance.
It was a contradiction that could not last. Six months on, the crackdown is being felt across the Chinese corporate world and in Hong Kong, which has positioned itself as the financial centre for Chinese international capital.
In the wake of Mr Lai’s arrest, those once-thriving investment banking businesses — once the source of so much capital — are now being downscaled in a move that has jolted Asia’s markets for credit and high-yield bonds.
“There is a domino impact from this on Chinese corporates,” says Patricia Cheng, an analyst at Hong Kong-based investment bank CLSA. “A lot of Chinese companies were relying on these AMCs as a source of capital [outside of China]. But that has dried up.”
Since April, Huarong and three state-owned peers — Cinda, Orient and Great Wall — have been forced by Beijing to fire staff and halt some of the operations of their Hong Kong-based investment banks, according to several people with direct knowledge of the situation.
Huarong has frozen all new projects connected to its investment banking operation, leaving the offshore operations of many Chinese companies starved of cash and unable to refinance their current debt. Several of its clients — from CEFC China Energy to Seaworld owner Zhonghong Holdings — have defaulted over the past year as they struggle to repay high-yield loans.
The quartet’s fixed-income investment operations have also been scaled back, leading to what some traders have described as a noticeable decline in demand for high-yield bonds in the Asian market.
“[The crackdown] is a prudent move because these AMCs are functioning as banks in this case,” says Minxin Pei, an expert on Chinese governance and corruption at Claremont McKenna College in the US. “Should the loans go sour, the AMCs will be saddled with the bad loans.”
The rise and partial fall of the centrally controlled asset management companies illustrates the ways that China’s financial sector and its economy have been transformed over the past two decades. The four groups, born out of a Chinese banking crisis, were created by the finance ministry in 1999 to absorb a pile of non-performing loans at the country’s four largest commercial banks.
In the first two years of operation, the companies took on about Rmb1.4tn ($200bn) in bad debt each — about 20 per cent of total outstanding bank loans — according to the Bank for International Settlements. Huarong, for example, took on Rmb408bn in bad debt from Industrial and Commercial Bank of China.
The recapitalisation of the financial sector was bankrolled by China’s central bank with 10-year bonds maturing in 2009, at which time the AMCs were expected to default and be liquidated, having accomplished their sole task of offloading the bad debt from the banking system.
“[The theory was that] we only had to wait until 2009 when the 10-year term of the bonds came due and the inept AMCs were unable to repay the banks the $170bn initial capitalisation,” says Jack Rodman, a restructuring expert who worked with the AMCs as an auditor in 1999. But they never collapsed. Instead, the banks were instructed to support the AMCs using tax payments, according to Mr Rodman.
Emboldened, the “bad banks” rapidly expanded to entrench themselves in China’s financial system, picking up licences for securities broking, insurance, trusts, property development, private equity investments and financial leasing. They also bought commercial banks in China and Hong Kong and employ thousands of people in dozens of separate business units dedicated to high-yield lending.
Cinda and Huarong, which had combined assets of Rmb3.3tn at the end of June, went public in Hong Kong in 2013 and 2015, respectively. The quartet’s distressed debt businesses in China still constitute the majority of their activity.
In Hong Kong, the companies carved out investment bank businesses to loan money to Chinese companies that state banks avoided. Among them were Hanergy, a renewable energy company that nearly collapsed in 2015 , and CEFC, which has been under pressure from Beijing to sell off global assets.
“When Huarong was at its peak, it was competing with traditional banks on lending,” says a person who has advised the company. “The others never got that big.”
One of the driving forces behind the AMCs was Mr Lai, chairman of Huarong since 2012. Small in stature, the 56-year-old from Jiangxi province in southeastern China often made himself available for interview with foreign media, an uncommon practice among Communist party officials.
China’s anti-corruption watchdog, the Central Commission for Discipline Inspection, said shortly after Mr Lai’s detention that he was being investigated for “legal violations”, an often used synonym for graft. Caixin, the Chinese financial magazine, reported in August that as much as $40m in cash was recovered from Mr Lai’s homes after his arrest. Huarong did not respond to requests for comment. Mr Lai could not be reached and his whereabouts are unknown.
China’s other AMCs
China Cinda Asset Management was the first AMC to open its books for an initial public offering. The 2013 offering raised $2.5bn but the company’s stock has performed poorly, down more than 36 per cent since the start of the year.
Great Wall, which took on bad debt from Agricultural Bank of China starting in 1999, was also expected to come to the market in Hong Kong this year, although those plans are now unclear.
China Orient Asset Management, which has also not made a public debut, was matched up with Bank of China in 1999 and took on the smallest amount of bad debt, about Rmb267.4bn, or 20.4 per cent of the bank’s outstanding loans.
However, several people with direct knowledge of the AMCs’ businesses say the crackdown is much broader than any one company or individual. Instead it is linked to a desire to control the level of debt built up by Chinese companies both in the country and overseas. Corporate debt in China , estimated by Fitch at 168 per cent of gross domestic product in 2017, is cited as one of the country’s greatest vulnerabilities, should economic growth slow and more defaults occur.
By mid-2017 a handful of conglomerates that had each spent tens of billions of dollars on overseas assets were under investigation by the banking regulator.
Many of these were the clients of the AMCs, which had used their state-owned credentials to issue dollar-denominated debt at rates of about 4 per cent. They deployed that capital into high-yield bonds or lent it at rates as high as 20 per cent to Chinese companies unable to secure offshore loans.
Between 2014 and September this year, the four companies raised $107bn. In 2017, at the height of their activity, the AMCs raised $30.7bn, more than half of which was issued by Huarong. So far this year it has raised just $2.3bn, representing a transformation of the business model.
Offshore corporate lending by the AMCs was often structured to appear like investments rather than loans. According to people involved in such deals, this helped them bypass credit-quality checks required at banks.
Corporate records show that the AMCs set up numerous companies in the British Virgin Islands or Cayman Islands that were used to lend to clients outside of China. In some cases where Huarong has lent to a listed Chinese company, only the basic framework of these deals has been made public.
In 2017, for instance, property developer Zhonghong Holdings made two large investments in overseas companies, buying a 21 per cent stake in US ocean-themed amusement park SeaWorld Entertainment for $449m, and 91 per cent of UK-based luxury travel company Abercrombie & Kent for $413m, company documents show. Both deals were backed by a Huarong subsidiary.
In April Zhonghong defaulted on unspecified debts, according to regulatory filings, leading to questions about the level of Huarong and other lenders’ exposure to the company.
The deal that many observers believe attracted strong government scrutiny and helped seal Huarong’s fate was its decision to lend to CEFC. Once the country’s largest private oil group, CEFC tried to buy a $9bn stake in Russia’s Rosneft last year, but after its chairman, Ye Jianming, was detained by Chinese officials in a corruption probe in February, the deal collapsed. A month later Huarong bought a 36 per cent stake in the CEFC unit behind the Rosneft bid.
CEFC has since defaulted on debt owed to Huarong and several other creditors, according to company regulatory filings, highlighting the level of risk Mr Lai’s company was willing to take. People with knowledge of the AMCs say this type of deal led to the crackdown because the loans allowed conglomerates to rack up debt and buy overseas assets without state supervision.
“They have got a signal from Beijing to rein in these operations offshore,” says the Asia chief executive of an investment bank that has worked closely with the AMCs. “Beijing is not comfortable with this activity.”
For Huarong the mistakes are adding up. In June it said first-half losses on financial assets, including many of the loans it has made, hit Rmb12.05bn ($1.8bn), up more than 150 per cent on a year earlier. Dragged down by those losses, profits for the first half of the year tumbled by 93 per cent to Rmb1.1bn.
In a rare recognition of the problems associated with aggressive lending to Chinese companies, it said it was curbing “excessive financing behaviour” that had led to many of the problems.
Global markets have felt the ripple of the AMCs pulling back from the high-yield bond market. Following Mr Lai’s detention, AMC bond buying tapered off in May and June in a trend that “was felt across the whole market”, says one senior trader with extensive experience of working with the companies.
“It’s probably been one of the contributing factors [to rising yields in Asia],” says Sandra Chow, an analyst at CreditSights. “It has raised some questions for what this means for the [bond] holdings of the AMCs and for the future support of the high-yield market.”
The AMCs have been an “experiment” in investment banking, according to an employee at one of the companies — a model that allowed state-backed groups to control a wave of capital departing China. But, as many AMC bankers in Hong Kong lose their jobs, and the wave of capital dries to a trickle, the experiment appears to have failed.
Asset managers looked for broad portfolios
Huarong developed a long list of aggressive overseas buyers as clients. As well as Zhonghong Holdings and CEFC China Energy, it also lent to Chinese conglomerate HNA and Huishan Dairy, according to a client list seen by the FT earlier this year. And following the near-collapse of Hanergy in 2015, Huarong denied its connection to the renewables group despite an FT investigation which revealed a corporate filing by Hanergy in the British Virgin Islands that suggested a Huarong subsidiary had loaned it money.
Risk-laden offshore lending was by no means restricted to Huarong. Several of China’s asset management companies have sought to deploy their capital in distant markets. In 2016, a British Virgin Islands-registered company backed by China Orient Asset Management lent $35m at 15 per cent annual interest to Australian property developer Hua Cheng International Holdings, which was struggling to access traditional bank loans and needed the funds to build an apartment complex in Sydney.
Hua Cheng defaulted on the Orient loan in August last year and failed to complete the project, Australian press reported at the time, causing uproar among the people, mainly Chinese nationals, who had already bought properties.
Nanyang Commercial Bank, a Hong Kong-lender owned by China Cinda Asset Management, lent at least $150m to Lander Sports Development for the acquisition of Southampton Football Club, Bloomberg reported at the time. Lander is owned by Chinese tycoon Gao Jisheng and the deal came just as Chinese regulators began cracking down on football club deals.
The turmoil at the AMCs has taken a clear toll on their share prices. Cinda’s stock in Hong Kong is down more than 36 per cent since the start of the year, while Huarong has fallen more than 60 per cent over the same timeframe.