Monday, August 23, 2004

Okay, back to some financial matters. A reporter called to ask me about the PBOC bailout of D'Long Group. I ended up having quite a few things to say. Here are the basic facts of the D'Long affair. First, D'Long is a private holding company started by the Tang family in Xinjiang. It began acquiring controlling shares in privatized dairy and food SOEs. In recent years, it expanded into financial services with the acquisition of minority shares in several city commercial banks and joint-stock banks. It also owns its own trust and investment company. Through a complex web of loan guarantees, loans, and shell companies, the group as a whole came to owe various banks some 20 to 30 billion RMB. In recent months, the Central Banking Regulatory Commission stepped up its investigation of D'Long, and after protestors blamed Bank of Communication for helping D'Long subsidiaries sell bad investment vehicles, D'Long became the focus of several central investigations. So, yesterday, instead of announcing the bankruptcy of D'Long, a fate that should befall on this Enronisque company, the PBOC announced a 15 billion bailout of the company. In this bailout, the Huarong Asset Management Company, originally set up to bailout state banks, would take over controlling shares of D'Long. Huarong would receive 15 billion in "relending" from the PBOC to help restructure the company. In the long-run, Huarong is expected to sell D'Long to private investors. Why?

I strongly suspect that the real motivation behind this bailout is, as always, to avoid a sudden surge in NPL ratio and to prevent a potential financial crisis from breaking out. Without knowing what would have happened had the PBOC not bailed out D'Long, it is difficult to say whether the PBOC did the right thing. On the one hand, the D'Long bankruptcy would mean at least 30 billion in new NPLs and perhaps more. Its complicated web of loan guarantees and triangular debt could destabilize the balance sheets of many of companies and banks, perhaps triggering a financial crisis that results in even more NPL. Most alarmingly, real deposit interest rates are currently negative, meaning that depositors are already a bit dissatisfied with leaving their money in the banking sector. A major financial scandal accompanied by illiquidity problems in several of China's smaller banks can trigger a local, if not national, bank-run. A PBOC bailout means that D'Long will continue paying interest to all of its creditors, and no new NPL will appear on their books. A potential financial crisis is thus prevented. On the eve of the 4th plenum, the last thing that Wen and Hu need is a major financial crisis.

On the other hand, this bailout sets a really bad precedence for other dubious private groups. the message basically reads: feel free to rack up a lot of bad debt; as long as your bad debt threatens the national economy, we will bail you out. True, the CEO of D'Long will likely go to jail, but investors in other private companies might encourage the management to take higher risks.

Some side commentaries: 1. The fate of the D'Long group shows the remaining problems with privatization. Because of D'Long's numerous connections and lax regulatory enviornment, the private firm still essentially faced soft-budget constraint. Even though it bought a lot of privatized SOEs, it is unclear whether the profit generated by these SOEs is "real."

I think this case on balance makes the CBRC looks bad. It had been aware of the D'Long problem since its formation in late 2002. Yet, little was done until the BOCO protests. Meanwhile, D'Long was allowed to set up more shell companies, raise more money, and get more loans. I fear more of this to come.

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