Volume III, No.2

March 25, 1999

Assessment of Legal Risk

In the rush to take part in one of the world's biggest markets, lenders have often ignored the central problem with China. It still is a communist country with a socialist command economy. Laws in China are never hard to find. The rule of law is. Without the rule of law, China will always be subject to an enormous legal risk that cannot be ignored no matter how favorable the market or credit risk may be. Nothing evidences this problem so well as the events surrounding the collapse of the Guangdong International Trust and Investment Corp. (GITIC).

GITIC was established in 1980. It is owned directly by the Guangdong provincial government. Guangdong is the province next to Hong Kong. It was one of the first provinces to benefit from Deng Xiaoping's reforms. GITIC was designed to emulate China International Trust & Investment Corporation (CITIC), the first and biggest such vehicle. Originally, these "Itics" were established by several provinces to spur long term development for infrastructure projects such as roads, power stations. At the time foreign bankers were not allowed to lend directly to mainland companies. Lending by China's state banks was restricted to state enterprises. "Itics" had foreign exchange certificates approved by China's cental bank, the People's Bank of China (PBOC). They were the only way to invest.

Over time "Itics" grew at a fantastic rate, both in number and size. By 1988 there were over 1,000 investing more than $30 billion. The number of Itics has since been reduced to 240, but they still control 3.3% of all mainland financial institutions' assets. Despite their size, there is no legal structure and very little regulation of these institutions. The National People's Congress (NPC) China's legislature has spent the last five years drafting a Trust Law to govern their activities. The most recent draft allows these companies to provide trustee services for securities investment, pension and social insurance funds. However, since there was no agreement as to the future use of these vehicles, the law will not be passed this year. In theory the PBOC has had regulatory authority over Itics. In practice, until recently, the authority has not been exercised.

Since there still is no legal framework for these organizations, the relationship between the "Itic" organization and its sponsoring provincial or municipal government has not been defined. It can be reasonably assumed that the provincial government "owns" the "Itic", but it does not necessarily follow that the provincial government is responsible for the debts of the "Itic". Also, there is no law governing guarantees by "Itics" of their subsidiaries or authorization of those guarantees by the relevant provincial government.

Eight months prior to its collapse, GITIC bonds were yielding 250 basis points above the rate of US treasuries. At this level, the market was pricing the bonds according to a credit analysis based on the credit history of the Chinese central government in Beijing. Since 1949, the central government has paid off all creditors. The legal risk was either ignored or totally discounted. The markets assumed that the bonds were to be rated as sovereign risk, despite that fact that the relationship between the "Itic"s and the sovereign was unknown.

Under a communist system all property belongs to the state. It was probably assumed that the central government in Beijing would ultimately stand behind any mainland debt. Up until GITIC, this assumption was correct.

In order to keep track of external debts the central government regulations required loans by foreign lenders to domestic Chinese enterprises be registered with the State Administration of Foreign Exchange (SAFE). "Registration serves two main purposes: to prevent domestic enterprises from incurring excessive foreign indebtedness and to let Beijing schedule repayments of foreign debt so that adequate reserves exist for this purpose. In short, registration is to protect foreign creditors. Unregistered debt is mostly unenforceable under Chinese law."⁽¹⁾ Registration does not in and of itself commit the central government to guarantee registered debt.

Under the law, foreign creditors are not allowed to submit debt registrations directly to SAFE. It is the obligation of the mainland debtor, like GITIC, to register the debts with SAFE. Loans to "Itic" subsidiaries incorporated in Hong Kong, so-called window companies, are exempt from registration since Hong Kong was and to a certain extent still is a different jurisdiction.

With no legal or financial limitations, by 1995, Gitic was able to enlarge its assets an estimated 100 times, while diversifying into a host of businesses, including securities brokerage, equipment leasing, silk textiles, leather and plastics, international trade, manufacturing projects, hotels and other real estate investments, as well as joint ventures with a number of prominent local companies.

Although it not licensed as a commercial bank, it also took deposits from 25,000 local depositors. It was able to attract these depositors by offering interest rates above the legal rate set by the PBOC. Again, under Chinese law, deposits that violate these regulations are void or illegal.

On October 7, 1998, the PBOC closed GITIC, Guangdong International Leasing, Guanxian Enterprise Development Company, GITIC Shenzhen. Their total debt stood at approximately US$ 4.5 billion. Their foreign debt was approximately US$ 1.93 billion, half of which were not registered with the State Administration of Foreign Exchange. As of September 1998, Hong Kong banks alone had an estimated exposure of $40.4 billion to other mainland international investment and trust corps.

On January 11, 1999, GITIC and Gitic Shenzhen, filed for bankruptcy. On January 16, the Guangdong High People's Court allowed the petition and GITIC and three subsidiaries were declared bankrupt. The court permitted neither comments nor appeals. Restructuring was neither considered nor allowed.

The bankruptcy and liquidation should occur according the mainland's 1986 bankruptcy law. The chief drafter of the law, Cao Siyuan, states that priority after liquidation (there is no provision for restructuring) would be given first to secured creditors, followed by employees, government claims, taxation authorities, and finally unsecured creditors. The law does not contain any distinction between registered debt, unregistered debt, deposits or governmental guarantees.

Secured creditors present a problem. The National Party Congress has yet to pass the constitutional amendment, which would allow the state to protect legal rights and interests in private property. Since a security interest is a legal interest in property, it still does not have official protection. The right may exist, but it may not be enforceable.

But there is no rule of law in China, only power. The power of the central government to avoid paying the debt verses the power of the international lending community to extend money. In this environment, the best predictor of strategy is not law, but Game Theory.

Some history. In the late 1970s, in order to secure his support, Deng Xiaoping promised Marshal Ye Jianying, Guangdong's 'godfather', that the central government would only fill top posts in Guangdong with local officials. Freed from the heavy hand of Beijing's bureaucracy and under the protection of Deng, Guangdong grew at a spectacular pace for almost twenty years.

Unfortunately, Guangdong's open environment brought two problems. First, by 1997 it was exposed to economic problems affecting the rest of Asia. Second, it lacked both legal and market discipline. Itic operations, holdings and financial conditions were opaque to the foreign bankers, who lent them money, the provincial governments, who owned them, and even to the regulators in Beijing, who were supposed to control them. Massive amounts of money were lost through bad investments, mismanagement and even theft. It was time for Beijing to reassert control.

In Guangdong, a rich province rife with corruption outside of both law and central control, Premier Zhu Rongji had the perfect sacrifice for his anti-corruption campaign. Unfortunately, Zhu used the wrong tools. Although Zhu has been brilliant in building up what the Chinese call zhidu ('systems ans institutions')⁽²⁾ but the"way several major banks, trusts and securities companies were closed down over the past year smacked of the dynastic 'rule of personality'."⁽³⁾

Premier Zhu exerts his control through the powerful and secretive Chinese Communist Party (CCP) Central Committee's Leading Group on Finance and Monetary Affairs, also known as the Central Financial Work Group. It members include the top State Council, finance, banking and regulatory officials Wang Zhongyu, Dai Xianglong, Liu Zhongli, Zhou Zhengqing, Jin Renqing, and Zhou Xiaochuan. Despite months of lobbying by senior Guangdong government officials, he was able to close down GITIC.

Premier Zhu, also placed his protégé, Wang Qishan as the senior vice-governor with authority over the economy, in particular, the banking sector. Together with Li Changchun, an adherent of President Jiang Zemin, the 'imperial inspectors' have been able to reassert control and marginalize the Governor, Guangdong native, Li Ruihuan.

When GITIC was shut down, no one knew the extent of its liabilities. When these became known, Beijing probably decided to try and shift some of the losses to foreign lenders. Beijing and Guangdong officials were initially virulent in their criticism of foreign bankers. According to the officials the bankers should have been more careful in analyzing the credit risk of the "Itics" and not their government owners. Second they should have followed the rules and registered their debt with SAFE. Under their analysis registered loans would be paid. Non-registered loans would not, because registration was required.

The charge had no legal basis. The responsibility and ability to register the loans was with the mainland borrower. Even if the bankers had been aware of the regulation, they might not have been able to register debts. Hong Kong window companies were in a different jurisdiction. Lenders had been assured by mainland lawyers and Guangdong officials that registration was not necessary. Finally, the bureaucracy in Beijing was always well aware that the regulations were being routinely violated.

All mainland financial institutions are required to file monthly reports to SAFE showing short term any short term loans. Short term lending was never registered with SAFE despite the regulations. SAFE never enforced its own rules.

A month after the shut down of GITIC, the leadership in Beijing had realized their mistake. The reputation of China as a the safe haven of Asia had been permanently tarnished. Secondary markets for GITIC bonds increased the spread over US Treasuries from 250 basis points to 1500. "The mainland government seems to have underestimated the 'G-shock' of the Gitic shutdown" ⁽⁴⁾

Money for all institutions, except Chinese Sovereign debt, dried up. The leadership changed tactics.

On November 6, central banker, Dai Xianglong, assured Hong Kong bankers that mainland institutions would be restructured rather than shut down. Guangdong Province was allowed to inject assets into Guangdong Enterprises (GDE), another investment arm of Guangdong provincial government, to keep it afloat. After repeated protestations that its fund raising arm, Guangzhou International Trust and Investment Corp (GZTIC), was an independent company and the municipality was not responsible for its debts, the city promised to support the firm in order to restructure its debts and improve cash flow.

Still this change of heart was not sufficient to affect the fate of GITIC and its subsidiaries, but not before the PBOC removed one its main assets. GITIC's brokerage and investment management business was transferred to Guangfa Securities Co. a solvent arm of the Guangdong provincial government. In the US and other countries such a transfer would be voidable.

The bankruptcy proceeding produced another major surprise. Despite the pronouncements of numerous officials including the People's Bank of China governor, Dai Xianglong, the GITIC liquidation committee made the decision that foreign lenders with State Authority of Foreign Exchange registered loans will not have higher repayment priorities than other creditors. At a press conference Dai Xianglong noted on January 28^th 1999 "If all the externally registered debt was paid, most domestic creditors would not be repaid at all." ⁽⁵⁾

In the same speech, Dai held out hope that GITIC would be restructured to head off a court imposed settlement. So the problem might be avoided. Of course by this time, Mr. Dai had the benefit of a meeting in Hong Kong with Mr Greenspan, Chairman of the US Federal Reserve, European Central Bank president Wim Duisenberg, Bank of Japan chief Masaru Hayami and more than a dozen other central bankers at a meeting organized by the Swiss-based Bank for International Settlements (BIS). No doubt Mr. Dai received some good suggestions.

By March, Mr. Dai felt that it was necessary to restructure ailing financial institutions. The more successful negotiations surrounding GDE and GZTIC are adequate proof of the need to avoid the perfunctory bankruptcy procedures used in the GITIC case.

Nevertheless the damage has been done. By attempting to invoke laws favorable to their policies while ignoring unfavorable laws, the Chinese leadership has place glaring spotlight on its lack of the rule of law. With its credit risk subject to a major reassessment, they have also succeeded in highlighting the need for intense scrutiny of legal risk.

The Chinese leadership and even foreign bankers are beginning to learn that there is a direct correlation between rule of law and economic recovery. The events surrounding the GITIC collapse are in sharp contrast to the reform process in Thailand. "According to Hong Kong Democrats leader Martin Lee Chu-ming, the correlation between democracy and financial soundness was obvious. 'Those nations that are in the process of recovering, including South Korea and Thailand, have done so only after jettisoning their corrupt former regimes through a democratic process"⁽⁶⁾

By: William Gamble, J.D., LL.M.

Emerging Market Strategies Company

1990 Pawtucket Avenues, Suite 1D
East Providence Rhode Island, United States 02914

Tel. 401-272-8906
Fax 401-272-8139
EMail : william@emergingmarketstrategies.com

1. Chang, Gordon, " Pay Them, Pay Me", Far Eastern Economic Review, p 33, 02/04/99.

2. South China Morning Post, "Financial Crises a Question of Control, 10/14/98.

3. Ibid

4. South China Morning Post, "Confusion Clouds Prospects for Mainland Corporates", 2/19/99.

5. South China Morning Post, "Dai sounds Gitic hope Confusion Clouds Prospects for Mainland Corporates", 1/28/99.

6. South China Morning Post, "Struggle to Solve Quandary of Reform", 1/2/99.

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