In a major step forward toward the resolution of China's serious banking problems, China Huarong Asset Management has announced the sale of RMB10.8 billion ($1.3 billion) worth of non-performing loans to an international consortium led by investment bank Morgan Stanley. While some small NPL deals have been made with domestic investors on a one-to-one basis, this deal is by far the biggest to have come out of China and is also aimed at international investors. So far, severe transparency and legal issues, as well as valution conflicts have prevented the speedy resolution of China's NPL problem.

Huarong was set up, along with four other asset management companies in 1999, to deal with the huge burden of non-performing loans that threaten China's banking system, estimated at RMB600 billion.

Huarong is the largest of the four asset management companies and by August last year had acquired non-performing loans worth RMB407.7 billion relating to 72,000 borrowers nationwide.

Huarong, which has been trying to resolve the debt problems of one of China's largest four state banks, the Industrial and Commercial Bank of China, sold the assets to the Morgan Stanley-led consortium in a manner which could lead to Huarong receiving 21 cents on the dollar from the deal.

"The deal is structured in a way that allows Huarong to participate in the value we create as partners," comments Dave Bednar, vice president of Morgan Stanley's Asia Pacific Real Estate Fund.

Under the terms of the deal, Huarong will receive approximately half its share in cash, while the remaining amount will depend on the success of the joint venture between Morgan Stanley in recovering the money owed.

Above a certain amount agreed between Morgan Stanley and Huarong, the AMC will receive the lion's share of the proceeds, comments Bednar.

Rating agency Standard & Poor's said in October it expected recovery rates of around 20% on China's bad loans.

The recovery process is expected to take up to five years.

A key role is being played by the World Bank's International Finance Corporation (IFC) which acted as a guarantor for Morgan Stanley when it accessed a local bank for RMB funding to acquire the loans.

Since China has a closed capital account, Morgan Stanley and the consortium are devising ways to remit their earnings out of China.

"We hope to get regulatory approval for capital remission structures that will be more attractive to international investors and will help the development of the NPL business in China," says Bednar. Debt recovery will be conducted along traditional lines, says Bednar, and will include court appearances to force foreclosure, debt for equity swaps, asset swaps and negotiated settlements with borrowers.

ICBC, as a state funding agent, was responsible for funneling huge amounts of money to manufacturing state-owned enterprises, many of which were never serviced, say analysts.

The majority of the loans being sold to Morgan Stanley which were made in the 1980s and early 1990s, says Bednar.

Of the companies which took out the loans, about one-third have been officially been categorized as non-operating, one-third as partly operating and one-third as operating.

Bank analysts agree that ICBC is one of the weakest state banks, just ahead of the Agricultural Bank of China, since its lending was directed toward a particularly inefficient sector of China's economy, heavy industry.

Most of these assets are in the shape of factories or factory land all the way along China's coastline.

China's bad loans, valued at $600 billion, could represent a huge market for foreign investors.

But some investors say that the real catch would be to acquire the bad loans held by Cinda, the AMC responsible for the management and disposal of bad loans made by the China Construction Bank.

CCB, in line with the sector approach favoured by Chinese banks, is responsible for real estate loans collateralized by prime residential sites. With the expected growth of China's economy, many banks, including Morgan Stanley, Goldman Sachs and Deutsche Bank have been trying for many months to take over these loans, but so far negotiations have not made significant progress.

Difficulties in valuing the loans and the lack of a smooth legal process mean that the vast bulk of China's non-performing the loans are still dragging down bank balance sheets.

The hope is that the present deal between the Morgan Stanley-led consortium and ICBC will act as a template for many more such deals, which the country desperately needs.