China Hypocritical? No, Just a Bit Itic-al

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TERRY MCCARTHY Shanghai and JAIME A. FLORCRUZ BeijingA French banker with large exposure in China asked an economist with a U.S. investment bank in Hong Kong last week for a briefing on what's really happening with China's foreign debt. Beijing announced Jan. 10 that it would not back the $4.4 billion in obligations (with just $2.6 billion of assets) of bankrupt Gitic, the Guangdong International Trust & Investment Corp. The banker sensed that something bad was happening but couldn't fathom just how bad. Like the rest of Hong Kong's financial community, he had a big shock coming.China has 240 itics, first set up in the 1980s to funnel foreign investment into provinces around the country. Foreigners had assumed loans to these entities were an iron-clad sovereign risk, guaranteed by the involvement of local government officials who routinely met them with fleets of Mercedes when they flew in to sign loan agreements. But many of the loans were frittered away on corrupt or unproductive projects--and more Mercedes. Now the hammer is falling, and it has hit the French banker hard. I explained that a lot of banks were going to lose a lot of money--and that a lot of people were going to lose their jobs, says the economist, who declines to be identified. The banker exploded. He said, 'You mean to tell me the government and the itics are not the same thing?' He was furious.As bankers rush to assess how much red ink they will require over the coming months and as shares in another form of China play--Hong Kong-listed red-chip companies with mainland links--plummet, a bigger truth is slowly sinking in: the rules have changed in China. Forced to choose between honoring foreign debts and ensuring domestic stability, Beijing is showing that internal concerns are paramount. And if that means French, German, Swiss, Korean and Japanese bankers will lose their shirts--and even their socks and underwear--so be it. (American and British banks, having similarly burned their fingers in Latin America in the 1980s, are far less exposed in China.)PAGE 1  |    |  
 
The other lesson of the itic saga--which spread last week to the northern city of Dalian, once favored by Japanese investors but now suspect since Dalian International Trust & Investment Corp. defaulted on loans to Japanese banks--is that all roads in China lead to Beijing. And on the financial highways, China's top traffic cop is Premier Zhu Rongji. Zhu is very firm, says Fred Hu, chief economist for greater China with Goldman Sachs in Hong Kong. A lot of other people would have blinked with all the pressure from foreign bankers.Zhu, whose efforts to reform the economy came under attack for much of last year, traveled to Guangdong in October shortly after Gitic was closed--with what was initially rumored to be just $2.4 billion in bad debts--to sort out the mess personally. There was considerable debate over whether to back the crumbling corporation, says a Chinese official in Beijing. The Guangdong government was prepared to pump in as much money as necessary to keep Gitic from going under, to preserve confidence in the province. One school of thought was to take the stance of xiabu weili [just this once], explains the official. The other was shayi jingbai [execute one as a warning to a hundred]. Foreign creditors waited nervously on the sidelines. Few expected the central government to pay off all of Gitic's foreign debt, but they had hoped to recover the $1.2 billion in loans officially registered by Gitic with the authorities in Beijing as foreign currency borrowing.Zhu came down hard: there would be no bailout. Wu Jiesi, deputized by the People's Bank of China to take charge of the liquidators, explained that China's bankruptcy laws do not give foreign creditors priority. The Prime Minister was looking at the bigger picture. Zhu can clearly see the frailties in the economy, says Andrew Ballingal, chief analyst for Schroders Asia in Hong Kong. The fading of foreign direct investment, deterioration of the export environment, all the pain ahead--this is battening down the hatches. Together the 240 itics have $10 billion in registered foreign debts, but bankers in Hong Kong estimate that, if unregistered debts are included, the total could be twice that figure. Or more. Liaowang, the weekly magazine put out by the government-run Xinhua news agency, recently estimated total itic debts at $30 billion.  |  2  |  
 
Zhu came down hard: there would be no bailout. Wu Jiesi, deputized by the People's Bank of China to take charge of the liquidators, explained that China's bankruptcy laws do not give foreign creditors priority.If Beijing's goal is to choke off unrestrained foreign borrowing by provincial governments and centralize control over China's finances, Zhu's willingness to let Gitic die means his economic reform agenda has not been completely blocked, argues Ballingal. Zhu has got serious religion about reform, he says. Closing down or merging the itics is consistent with his reform credentials, as are much-publicized attempts to reduce corruption and smuggling, divest the army of its businesses and clean up the financial system.Chinese bankers and finance officials held a three-day meeting in Beijing last week to sketch out ways of closing and merging the itics to reduce their number to fewer than 40. But no matter how the itics are rearranged, foreign lenders aren't likely to rush back in. Over the short term, China's chances of getting fresh commercial credit are close to zero. The government may have underestimated the potential fallout in the international financial markets, says analyst Hu. The new environment suggests that guanxi, or personal connections, will no longer count for much. What will bankers base their credit on? asks a Western financial executive in Beijing. Bank accounting standards here are not up to international levels.To reap the long-term benefits of financial reform, China must endure the short-term pain of a severe credit crunch--just as it needs to support industry to curb labor unrest. Andy Xie, chief China economist for Morgan Stanley Dean Witter in Hong Kong, points out that if foreign creditors don't roll over debts for red-chip companies, most of which are severely overstretched financially, the latter could start going under too. This thing is getting bigger and bigger, says Xie. The unreported debt of China's companies is much larger than the government thought. But there is no way to back down now. Zhu Rongji is playing a dangerous game. But the smart money knew that all along.  |    |  3