By Anne-Marie Neagle Richard Mazzochi Andrew Fei and Stella Xiaoxue Wang
Foreign investors continue to show strong interest in accessing China’s growing market for non-performing loans (NPLs). So much so that the recent China-U.S. Phase One Trade Deal includes a commitment by China to further open up its NPL market to U.S. firms. Specifically, China has agreed to allow U.S. financial services firms to apply for provincial (and eventually national) asset management company licenses, which would allow them to acquire NPL portfolios directly from Chinese banks. At the time of writing, the first such license has already been granted and more are expected in the future.In this article, we explore the significance and potential business opportunities presented by this aspect of the Phase One Trade Deal. However, to better understand its implications, we begin with a high-level overview of the existing macroeconomic and regulatory landscape surrounding China’s NPL market. For those who are already familiar with the background, please refer directly to Part II of this article further below.
Part I: Background on China’s NPL market
- Macroeconomic context
As China’s economy enters the “new normal” and undergoes significant transformations and reforms, Chinese companies – both private enterprises and state-owned enterprises – are experiencing rising debt levels. As a result, both official statistics and unofficial estimates indicate that the amount of NPLs held by Chinese financial institutions and corporations are on the rise.
Given uncertainties currently surrounding the regional and global economy, the trend of rising NPL levels is expected to continue in 2020, if not accelerate. As NPLs have a countercyclical component, we expect they will continue to be of interest to investors notwithstanding recent economic headwinds.
As part of its efforts to address the NPL issue and maintain financial and economic stability in China, the Chinese government is encouraging foreign investors to participate in China’s growing NPL market through a number of channels.
- Key players in China’s NPL market
Despite the fact that new channels for foreign investors to participate in China’s NPL market are beginning to emerge, the market continues to be dominated by the four state-owned national asset management corporations (National AMCs).
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 (currently defined as transferring three or more NPLs). For the purposes of this article, the term NPL portfolio refers to a portfolio of more than three 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 (Local AMCs, together with National AMCs, the 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.
There are now approximately 60 Local AMCs and we expect more to be established in the future. In some provinces, Local AMCs play an increasingly important role in acquiring NPLs from local commercial banks.
- Transactions in China’s NPL market are divided into Primary Market Transactions and Secondary Market Transactions
Generally, only AMCs are allowed to purchase NPLs on a bulk basis from Chinese banks. The acquisition of NPL portfolios directly from Chinese banks and other Chinese financial institutions is referred to as a 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.
- Channels for foreign investors to participate in China’s NPL market
Over the past several years, new channels for foreign investors to access China’s NPL market have emerged while existing channels are becoming more streamlined and investor-friendly.
The key existing access channels are summarised below. For further information, please refer to our earlier publication on China’s NPL market.
- Purchasing NPL portfolios from AMCs
National AMCs: Foreign investors can purchase NPL portfolios from National AMCs through a competitive bidding process. This is a well-established channel for foreign investors to acquire NPLs and has been available since 2001. 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, because the relevant regulations are not clear on this point.
- Purchasing NPLs (on a non-bulk basis) from Chinese commercial banks (including pursuant to the Shenzhen NPL Pilot Program)
Generally, foreign investors cannot purchase NPLs in bulk directly from Chinese commercial banks. However, foreign investors may discuss the types of NPLs they are interested in acquiring 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. An alternative is for a Chinese commercial bank to issue NPL-asset-backed securities (see 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). The QEX operates one of China’s largest NPL trading platforms and has, since the establishment of the NPL Pilot Program, handled a large number of cross-border NPL transactions. Similar pilot programs have begun in other Chinese cities and provinces.
- 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).
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.
- Entering into joint ventures with National AMCs
Foreign investors can, and have, entered into joint ventures with National AMCs for the purpose of acquiring and managing NPL portfolios.
- 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.
- Establishing wholly foreign-owned “non-licensed” AMCs
Foreign investors have successfully established wholly foreign-owned AMCs in China. Since around 2017, relevant authorities in Beijing, Shanghai and Tianjin have encouraged foreign asset managers to invest in the PRC NPL market and approved the establishment of so-called wholly foreign-owned AMCs on a case-by-case basis. However, we note that 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). Wholly foreign-owned AMCs that can only participate in the secondary market are commonly referred to as “non-licensed” AMCs.
Part II: Implications of the Phase One Trade Deal
- Article 4.5(2)
Article 4.5(2) of the recently concluded 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) states as follows:
“China shall allow U.S. financial services suppliers to apply for asset management company licenses that would permit them to acquire non-performing loans directly from Chinese banks, beginning with provincial licenses. When additional national licenses are granted, China shall treat U.S. financial services suppliers on a non-discriminatory basis with Chinese suppliers, including with respect to the granting of such licenses.”
There are a few noteworthy aspects of this provision, and each is discussed below.
- Coveted Local AMC licenses
China has agreed to allow U.S. financial services firms to apply for coveted Local AMC licenses, which have previously not been available to foreign investors. Compared to the existing foreign-owned “non-licensed” AMCs which can only participate in Secondary Market Transactions, a U.S. financial services firm with a Local AMC license should be able to participate in Primary Market Transactions by acquiring NPL portfolios directly from financial institutions in the Chinese province in which it is licensed. There may be pricing, quality of supply and other advantages associated with participating directly in Primary Market Transactions.
- Non-U.S. firms?
Article 4.5(2) only extends this opening-up measure to U.S. financial services firms. However, to the extent financial services are covered by a most-favored nation (MFN) clause in a trade agreement between China and another jurisdiction, then arguably this favorable opening-up measure may, over time, extend to financial services firms in that other jurisdiction. Having said this, we expect local AMC licenses to be granted to U.S. firms in priority to non-U.S. firms given the express provisions in relation to U.S. firms in the Phase One Trade Deal.
- Details will be important
Article 4.5(2) itself does not contain much detail. Overtime, 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 AMC licenses as well as the scope of permitted business activities for these foreign-owned Local AMCs. For example, market participants want to know if foreign-owned Local AMCs may engage in the same activities as a domestic Local AMC in the relevant province. To the extent that Chinese-owned Local AMCs are permitted to engage in a broader range of activities in the future, foreign-owned Local AMCs may also benefit from such regulatory relaxation.
These policies and guidelines may come from either the relevant provincial governments or the China Banking and Insurance Regulatory Commission (CBIRC), which is the main regulator overseeing China’s banking sector and financial institution NPL market.
- Potential national AMC licenses down the road
Article 4.5(2) states that when additional National AMC licenses are granted, China will treat U.S. financial services firms on a non-discriminatory basis with Chinese firms.
To date, China has not granted National AMC licenses to anyone other than the existing four National AMCs. Therefore, the substantive content of Article 4.5(2) is that, if and when China opens up its national NPL market, U.S. financial services firms may be able to, over time, obtain National AMC licenses on the same basis as their Chinese counterparts, and participate in the national NPL market on the same footing.
- Looking ahead
Article 4.5(2) of the Phase One Trade Deal presents new business opportunities for U.S. and potentially other foreign financial institutions and investors. Overtime, Article 4.5(2) and other aspects of the Phase One Trade Deal will result in greater foreign participation in China’s financial markets and financial services sector, and lead to greater competition, more innovation and better quality of service.
While Chinese regulators have taken and will continue to take steps to further open up the country’s financial markets and financial sector (including the NPL market), ensuring financial stability will continue to be their 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 emphasize strict compliance with regulatory requirements in order to prevent systemic risks. The flip-side of national treatment of foreign investors and financial institutions in China is that they are expected to fully adhere to Chinese laws, regulations and policies in the same manner as their Chinese counterparts.
King & Wood Mallesons has decades of experience in successfully helping foreign companies establish and expand their operations in China, obtain financial services licenses, enter into joint ventures with Chinese financial institutions, invest in the Chinese financial services sector and comply with applicable Chinese laws and regulations. We have also been active in China’s NPL market since its inception in 2000. We regularly act for the AMCs, foreign and domestic investors and other participants in all types of domestic and cross-border NPL transactions.
Should you wish to discuss what Article 4.5(2) and other aspects of the Phase One Trade Deal mean for you or your business, please contact a member of our cross-border team.
In the meantime, we will continue to keep you updated on important Chinese financial regulatory developments through our regular client alerts and in-depth analysis.