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Financing China Costs Poised to Rise With Government Decision on CDB Debt

Updated:2011/5/3 10:48

China Development Bank Corp.’s private-equity unit sports three bronze busts of Communist Party leaders in its Beijing lobby. Chairman Mao Zedong is there, and so is his eventual successor as leader, Deng Xiaoping. Then there’s Chen Yun, once China’s top economic planner.

The state-owned policy bank, created in 1994 to support the government’s economic and infrastructure goals, has been led since 1998 by Chen’s son, 66-year-old Chen Yuan. His father, like Deng, is among the Communist Party’s so-called eight immortals, who wielded power in the 1980s and 1990s, Bloomberg Markets magazine reports in its June issue.

The younger Chen, who led CDB through the Chinese banking crisis more than a decade ago by offloading 100 billion yuan ($15.3 billion) in bad debt, has made the bank the engine of the national government’s economic development policies. CDB had $687.8 billion in loans on its books at the end of 2010, more than twice as much as the World Bank.

The Beijing-based institution financed the Three Gorges Dam, the world’s largest hydro-electric project, and helped pay for the expansion of China’s most successful companies, including Huawei Technologies Co. It set up a private-equity fund in December.

“Chen’s bank has been a crucial financier to China’s rapidly expanding economy,” says Fred Hu, founder of Beijing- based Primavera Capital Group and a former Greater China chairman at Goldman Sachs Group Inc. “CDB has really assumed a prominent role in China’s economic development.”

Special Financing Bonds

That role may be about to change. The bank is fighting a decision by Premier Wen Jiabao’s cabinet to strip it of one of its biggest competitive advantages: special financing bonds. Unlike debt issued by other state-owned banks, CDB bonds are classified at the same level as sovereign debt by the government. Banks that buy the bonds can count them at a zero- risk weighting on their balance sheets.

Wen’s plan reclassified CDB as a commercial bank instead of a policy lender. That means the bank, almost completely financed by 3.95 trillion yuan in bonds as of May 2 would have to pay more to borrow money.

The change comes as analysts question its investments in countries with high-risk debt-ratings, including Venezuela, and the bank’s domestic loans are threatened by any popping of China’s property price bubble.

Obstacle to Profit

“I hope the country makes the decision to extend their sovereign status because, if they don’t, their yields will definitely go up; it will be an obstacle to its profit,” says Liu Kegu, a former CDB vice governor who’s now an adviser to the bank in Beijing.

Wen’s government wants CDB to compete on an equal footing with other state-owned banks that now have commercial bank status, such as Industrial & Commercial Bank of China. (1398) While still majority owned by the state, those lenders have sold shares to global investors during the past decade.

Yan Qingmin, assistant chairman of the China Banking Regulatory Commission, says the commercialization will increase CDB’s “capitalist skills.”

“Their cost of capital is low; that is their advantage compared to other commercial banks,” Yan says.

CDB is the second-biggest bond issuer in China after the Ministry of Finance, accounting for about a quarter of the country’s yuan bonds at the end of 2009, according to the bank’s annual report.

Resisting the Conversion

Losing its sovereign status may boost CDB’s interest costs by as much as 30 basis points, says China International Capital Corp., the country’s first joint-venture investment bank. That’s on top of four interest-rate increases by the People’s Bank of China that raised the country’s one-year bank lending rate by 100 basis points from October to the end of April. (A basis point is 0.01 percentage point.)

Chen is resisting the conversion, hailing the benefits of banks designed to support government goals.

“China Development Bank’s role in promoting the sound and rapid development of China’s economy and society has been irreplaceable,” Chen wrote in the January issue of China Reform, a finance magazine.

Chen has won at least a temporary reprieve. On March 29, the government extended the special financing status through the end of 2012. The bond ratings will be reviewed after that “according to the bank’s commercialization reform,” the CBRC said.

‘Consider Credit Risks’

Chinese banks say commercializing CDB would force it to adhere to the same business principles as other lenders. CDB can currently underwrite projects that are “too big” for most of the country’s banks, says Chris Cheng, general manager of global trade services at Bank of China Ltd. (3988)’s corporate banking unit.

“We have to consider credit risks, country risks, these sort of things,” Cheng says. “Their main task is to support China’s exports.”

CDB in 2009 eclipsed Bank of China, the world’s seventh- largest by market capitalization, as the country’s biggest foreign-currency lender, with $97.4 billion compared with Bank of China’s $96 billion.

Outside China, politicians and labor unions complain that CDB’s subsidized credit gives unfair advantages to both the bank and its industrial customers, such as telecommunications giant Huawei Technologies.

Getting an Edge?

U.S. Senators Joseph Lieberman, a Connecticut independent, and Jon Kyl, an Arizona Republican, wrote to the U.S. Federal Communications Commission in October, questioning whether Huawei’s loan from government-owned banks gave it an edge over U.S. rivals. CDB gave ZTE Corp. (763) and Huawei, both based in Shenzhen, a combined $45 billion line of credit starting in 2004 to provide financing for customers, including Mexico’s America Movil SAB.

Huawei and ZTE “received tens of billions of dollars in export financing and low- to no-interest loans that needn’t be repaid from the Chinese government,” Kyl and Lieberman, along with Senator Susan Collins, a Maine Republican, and Representative Sue Myrick, a North Carolina Republican, said in the letter.

“It is the amount and it is the scale,” says Jeremie Waterman, senior director for Greater China at the U.S. Chamber of Commerce. “There is a growing concern that these loans combined with other advantages are allowing these companies to compete on steroids.”

Huawei says the Chinese government doesn’t influence its activities.

‘No Puppet Master’

“There is no puppet master,” spokesman Ross Gan says. In February, Huawei posted a letter on its website that said the lines of credit “are actually designated for Huawei’s customers, not Huawei.”

Ken Hu, chairman of Huawei USA, said in the letter: “Huawei recommends loans to our customers and, once taken, our customers are responsible for paying the principal and interest directly to those banks.”

CDB has also sparked controversy with its support of the Chinese government’s efforts to expand the country’s solar and wind industries. CDB approved more than 126 billion yuan in credit facilities in the second half of last year for Chinese solar companies, including Yingli Green Energy Holding Co., according to Bloomberg New Energy Finance. In March, Linuo Group Co., another solar firm, said it had secured a 12 billion yuan loan from CDB.

Government Support

It’s financing like this that led Marlboro, Massachusetts- based Evergreen Solar Inc. (ESLR) to announce in January that it would close a U.S. factory while keeping a Chinese one open because it can’t compete with companies that, it says, get “considerable government and financial support.”

The administration of U.S. President Barack Obama in October agreed to investigate a complaint by the United Steelworkers that China gives clean-energy producers subsidies that violate World Trade Organization rules.

“It’s been a long-term aggravation with the Chinese banks, including China Development Bank,” says Gary Hubbard, a Washington-based spokesman for the union. “It is all because China provides these subsidized interest-free or low-interest bank loans and provides lots of other subsidies.”

Analysts, meanwhile, are raising concerns about CDB’s loans to foreign governments. In August, CDB completed a $20.6 billion oil-for-loans agreement with Venezuela, negotiated with the help of New York law firm White & Case LLP. The loans commit Venezuela to deliver at least 250,000 barrels a day to China this year and 300,000 barrels starting next year, until the loan is repaid.

‘Shrewd Banker’

Oil was also behind $25 billion in loans in 2009 to two state-owned Russian companies and a $10 billion loan to Brazil’s state-run Petroleo Brasileiro SA. (PETR4)

This kind of lending may hinder Chen’s efforts to modernize CDB, says Erica Downs, a former Central Intelligence Agency analyst who authored a 105-page report on CDB for Washington’s Brookings Institution.

“Here’s this guy who has a reputation for being a shrewd banker, who has a reputation for having created a whole culture of risk management in CDB, and now he’s lending all this money to Venezuela,” Downs says of Chen.

Market researcher CMA Datavision ranks Venezuela, along with Greece, as having the highest risk of default. Standard & Poor’s rates the country’s long-term debt BB-, the third-highest noninvestment grade. Chen told reporters on April 14 that backing loans with oil shipments “effectively keeps risks to a minimum level.”

Communist Party Elite

Chen, like his father before him, is a member of the Communist Party elite. As a student at Beijing’s Tsinghua University in the 1960s, he studied English while his classmates took to the streets as Red Guards, Primavera Capital’s Hu says.

“He is really a sophisticated economic and financial expert,” Hu says. “He is very private, maybe a bit aloof. He likes to read. Mostly economic stuff.”

China Development Bank has its roots in six state-owned investment companies that were under the State Planning Commission, the Mao-era organization that was overseen for years by Chen’s father. The elder Chen helped draft China’s first five-year plan in the 1950s and emerged in the 1980s as an elder leader opposed to Deng’s program of rapid economic reform.

The bureaucracy created by Chen Yun, a former type-setter and labor organizer, set prices and production quotas for everything from coal to bicycles.

Basket Case

The new bank was established in 1994, and a year later the elder Chen died. His son, who was then a deputy governor at the central bank, got passed over for the top job there and took over CDB about three years later. He inherited a basket case. Nonperforming loans stood at 33 percent, Chen said in a 2003 interview with the Xinhua News Agency.

Chen brought the lender’s risk management system up to global standards, rejecting 94 loans sought by the government from 1998 through 2003 because they were in unpromising sectors such as steel, cement, glass and textiles, according to He Yuxin, a Hong Kong-based analyst at China Resources Holdings Co.

“Even though it is a government arm, it is really treated by the marketplace as a well-managed and well-run modern financial institution,” says Jacob Frenkel, chairman of JPMorgan Chase International and a former governor of the Bank of Israel.

Frenkel, 68, is an unpaid member of CDB’s international advisory board, a group that has included former Australian Prime Minister Paul Keating and former U.S. Secretary of State Henry Kissinger, according to a November 2010 bond prospectus.

‘Global Thinker’

Peter G. Peterson, co-founder of Blackstone Group LP (BX), the world’s largest private-equity firm, met Chen more than 25 years ago and was impressed with his multinational outlook. Chen later joined the board of the Peter G. Peterson Institute for International Economics in Washington.

“He stood out for his focus on the world economy at a time when many were focused on national economies; Chen Yuan was and is a global thinker,” Peterson says in an e-mail.

Chen’s focus may now be closer to home. His bank helped pioneer the country’s network of local-government-owned companies that borrow money for bridges, sewers and subways, which other lenders followed. The counties and cities rely on ever-rising land sales to pay back CDB for the financing.

In Tianjin, a coastal city about 140 kilometers (87 miles) southeast of Beijing, CDB underwrote new highways and a light- rail line.

AAA Rating

In 2005, the bank loaned 50 billion yuan to Tianjin Binhai New Area Construction & Investment Group Co., a company set up with the Tianjin government. The company issued 2.9 billion yuan of bonds in December 2009 with a top AAA rating from China Lianhe Credit Rating Co. in Beijing. In 2009, it reported a negative cash flow of 6.8 billion yuan, according to its annual report.

CDB’s loans to Tianjin Binhai are to be paid back with revenue from land sales, and the guarantor of the bonds is another local-government platform that relies on lending, according to the bond prospectus.

The income stream could be at risk if China’s long-running property boom reverses and local real-estate prices fall. Land provided 41 percent of Tianjin’s income in 2009, according to China Index Academy, a Beijing real-estate research firm.

‘Credit Quality Problems’

“This could be a source of credit quality problems, possibly leading to debt rescheduling,” says David Marshall of CreditSights Inc. China faces a 60 percent risk of a banking crisis by mid-2013 in the aftermath of record lending and surging property prices, according to Fitch Ratings.

Yan, of the regulatory commission, says just one-third of local-government loans have been issued for projects with sufficient cash flow to cover repayments.

“Local-government-backed financing vehicles in Tianjin have no risk,” Tianjin Mayor Huang Xingguo says.

Chen says the bank has about 700 billion yuan in outstanding loans to local governments.

“I’m not worried about them defaulting because China Development Bank has a special relationship with the government,” he says, speaking in an April 14 interview from China’s tropical island of Hainan. “CDB has been financing local governments from the outset.”

New Privileges

Even as the Chinese government may take away some of CDB’s privileges, it continues to grant new ones. CDB Capital, the bank’s private-equity arm led by Zhang Xuguang, is licensed by China’s cabinet as the only Chinese bank allowed to make direct investments. In a December brochure for its fund of funds, CDB Capital said it “inherits CDB’s primary goal of servicing the state.”

CDB Capital’s investments include the 7.8 billion yuan China-Africa Development Fund, which was inaugurated by Chinese President Hu Jintao in 2006. It also holds stakes in state-owned companies such as Qingdao Beihai Shipbuilding Heavy Industry Co. and Shanghai -Meishan Iron & Steel Co., according to the brochure.

“China’s private-equity industry is very particular,” Xie Ping, vice president of China’s $332 billion sovereign wealth fund, which along with the Finance Ministry owns 100 percent of China Development Bank, told business leaders at Beijing’s Diaoyutai State Guest House on Dec. 28. “It has the imprint of the state.”

If CDB Capital pleases its Communist Party bosses, Chen Yuan may yet find a statue of himself in the private-equity unit’s Beijing lobby, next to that of his father. That may depend on whether he can navigate the bank’s loss of its special lending status and can rein in its debt risks at home and abroad.

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