Several countries need to deal with bad debt or NPA problem as quickly as possible. Opening markets to the most experienced, often-foreign, firms to purchase assets could be one of the solutions. Can anyone take this politically unpalatable decision

In the late 1980s it was estimated that the land on which the Japanese Imperial Palace in Tokyo is built was worth more than all the land in California. Through high land values and low interest rates, Japanese had engineered one of the greatest asset price bubbles of all time. The Bank of Japan raised interest rates late in 1989 and burst the bubble. The consequence was a financial system with a massive load of bad debts. With capital infusions from the government, the banks were bailed out and the crises halted, but it stopped there. The free money allowed the banks to delay the recognition of the bad debts. The result was two decades of little or no growth.

Sound familiar? It should. Real interest rates especially in emerging markets over the past few years have fallen sharply often to negative levels. This fuelled a credit boom and often sky rocketing asset prices. The US Federal Reserve is slowing its money machine. Interest rates are starting to normalise. Emerging market currencies are depreciating creating slower growth and higher interest rates. Inevitably the bad debts are beginning to metastasize. If they can be quickly excised then money can be loaned to healthier businesses and growth returns. But often that is not what happens.

In efficient legal systems creditors and debtors have two choices: formal bankruptcy court procedures and informal restructuring. Courts take time and cost money, but invoking the power and protections of the state allows an orderly priority among creditors. In certain situations it can provide a debtor with temporary protection until the business improves. Informal processes move faster and usually require additional collateral or an asset exchange. Both methods can include a reduction of debt, a restructuring of the capital structure and a transfer of equity.

The problem is that most of the world does not have efficient legal systems. Bankruptcy and collection processes can take years if not decades. Well-meaning laws are often heavily biased in favour of the debtors. This allows multiple loop holes for wilful dead beats. Emerging markets are also relationship-based systems. They are dominated by family owned companies. These wealthy families are interested only in maintaining a dynasty. They have no intention of transferring equity which would diminish their control. With weak courts and multiple methods to delay the debtors only real incentive to restructure is to regain access to credit. But if the debtor is a well connected or state owned firm and the creditor a state bank, often even this incentive is useless.

Still there is some movement. In Europe distressed debt was the best hedge fund strategy with funds returning 18%. Banks including the Spanish bank, Santander, the German bank, Commerzbank, and the British insurance company, Aviva have been selling assets. Despite the objections of the government, even Italian banks including UniCredit and Intensa are in talks to sell distressed debt to the American private equity firm KKR.

There are some standouts in the developing world. In 1998 after the Asian crises the Philippines government passed a law that provided incentives for the banks to sell non-performing loans (NPLs). In 2004 the state owned Land Bank of Philippines auctioned off half of its distressed debt. Soon foreign investors were flocking to the Philippines looking for deals. This created a healthy market, better expertise and better prices from increased competition.

Sadly this example is not common. In Brazil as the economy slows, the problems grow. Non-performing loans grew by 11% last year and the number of firms seeking legal protection against creditors grew by 53%. A number state owned bank, BNDES, and Banco do Brasil SA, Latin America’s largest bank by assets have said that they are considering selling bad debt. However the leader in selling distressed debt is the local branch of the Spanish bank, Banco Santander Brasil, SA. Other local banks attempt to keep the process in house. Itau Unibanco Holding SA and Banco Bradesco plan to sell bad loans to their own companies. There are few investors for company loans because the restructuring process is more difficult than for consumer credit and can take more time up to a decade.

Indian companies are also in trouble. Over the next 12 to 15 months the top 100 Indian companies will need to refinance an amount estimated to be Rs2 trillion. This amount is equal to about 27% to 29% of aggregate net worth of the banking system. Many of these companies are already in trouble. There are about 20 companies already in distress and their debt equals almost a quarter of the refinancing requirement. Another 20 companies representing an additional quarter of the refinancing has an elevated risk.

To get rid of the bad loans, banks are ‘selling’ more to Asset Reconstruction Companies (ARC), but not for money. They are selling the loans for security receipts (SRs), which only become cash after recovery from an account. The actual recovery process is continuing to be a challenge for the ARCs.

The recent authorization by the Reserve Bank of India (RBI) of private equity (PE) funds and non-banking finance companies (NBFCs) to participate in auctions of NPLs by banks is a step forward but may threaten the ARCs. Restricting participation of foreign institutional investors (FIIs) doesn’t help. These large international fund managers have the requisite know-how and appetite to contribute effectively to the resolution effort.

Perhaps the oddest methods of offloading NPLs belong to China. Chinese corporate bank borrowing has also exploded. The debt of 945 listed medium and large non-financial firms soared 260% to Rmb 4.74 trillion ($777 billion) by 2013 from Rmb 1.82 trillion ($298 billion) in 2008. Total corporate debt in China is estimated to be $12 trillion or 120% of GDP. In contrast total corporate debt in the US is only $9 trillion or 64% of GDP.

As borrowing costs go up due to tightening bad loans will increase. But since the collapse of GITIC 12 years ago, China has rarely allowed a corporate failure. Bankruptcies and defaults could spark social unrest among workers and investors, so corporate failure is to be avoided at all costs. This has not stopped the bad debts from increasing. They are up 38% from a low point two years ago.

During the banking crises at the start of the century the four largest banks off loaded their debts into so called Asset Management Companies (AMC) in exchange for ten year bonds at the face value of the loans. Ten years has come and gone and the bonds were rolled over. The AMCs never wound down as originally envisioned. Instead they have grown and now at least one, Cinda, has listed in an IPO. After studying these things over the past decade, I have not found one instance where they actually sold or restructured a bad loan.

Now the government has established 20 exchanges around the country for bad loan sales. Not surprisingly there is no data on exactly how many NPLs have been sold. Often the easiest way to get rid of bad loans is not to bother at all. Instead the firms have permission to raise fresh capital with hybrid securities.

As the credit cycle turns the lesson from Japan is clear. To avoid potentially decades of slow or no growth the bad debt problem has to be dealt with as quickly as possible. It requires a free market solution. Countries must open their markets to the most experienced often-foreign firms to purchase assets at often deep discounts.
 

The problem is that this solution is so politically unpalatable that it will not be tried, dooming many emerging markets to lost decades.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)