Market Confidence in ‘China Inc.’ Appropriately Shaken — G.I.T.I.C. Bond Default A taste Of What Is To Come?

(Washington, D.C.): In recent days, the global financial crisis rocking emerging markets has
fulfilled a long-standing prediction of the William J. Casey Institute: Communist China would not
be able to continue indefinitely to conceal its economy’s grave vulnerabilities.

According to an article prominently featured in the business section of yesterday’s New
York
Times, Guandong International Trust and Investment Corporation (GITIC) recently failed
to meet
an international bond payment to its agent, Chase Manhattan Corporation. Unlike Western
syndicated loans to investment trust corporations (or ITICs) like GITIC, bonds cannot be simply
rescheduled or restructured by the lenders. Bond repayments are either made on time or are
defaulted upon — denying creditors the option of rescheduling debt repayments.

This is largely because investment banks, which typically lead the underwriting of such bond
offerings, offload the bulk — or all — of the credit exposure on their books to other investors and
creditors in the so-called secondary market. This is why the Casey Institute has long warned
against that the purchase of certain Chinese bonds (e.g., those offered by China International
Trust and Investment Corporation (CITIC) run by the notorious Chinese arms-dealer, Wan
Jung.⁽¹⁾ Such investments are not only freighted with
national security-related implications.
They also pose a real danger of default, particularly given the non-transparent nature of such
enterprises.

‘Say Goodnight, GITIC’

The meltdown of GITIC, the PRC’s second-largest investment trust corporation, and the
Chinese
government’s response to it — namely, closing the Guandong concern’s doors — has generated a
shockwave of market anxiety. After all, the primary purpose of ITICs like Guandong’s is to
channel Western investment and liquidity into China, ostensibly to facilitate trade and exports. In
practice, they are often huge state-associated conglomerates, some of which borrow heavily in
foreign markets and use these funds for infrastructure projects, acquisitions and other corporate
expansion activities. Others, like CITIC, appear responsive to the priorities of China’s Military
Commission and security services.

With a little luck, the GITIC experience can be seen for what it is — “early warning” of a
looming
and much more serious financial crisis in China — and, therefore, may prove to have a silver lining.
What will be required is a serious and comprehensive review of the Chinese economy by Western
public and private sectors. If such an effort is promptly and conscientiously undertaken, it may
yet be possible to avert far greater economic and strategic costs to those who have heretofore
seen little downside risk to large capital flows to the PRC.

The Tip of China’s Financial Iceberg?

The Chinese government’s decision to close down the Guandong ITIC apparently came after
it
concluded that the investment trust company had no hope of extricating itself from a mountain of
short-term hard currency debt it had attracted on international markets (some of which is said to
have been “unauthorized”). It is striking that, in the wake of this official action (or, more
precisely, inaction), a number of prominent financial commentators, Western
investors and lenders
have gone to considerable lengths to portray the PRC’s willingness to step aside and watch one of
its flagships go under as a positive step — as it is. They contend that it is evidence that China is
maturing as a market-player and better understands the folly of propping up losing enterprises like
GITIC. Ironically, many of these same market players have privately acknowledged that the
Chinese government’s failure, at least to date, to bail-out GITIC is a source of disappointment
and concern to shareholders.

In fact, the closing of GITIC could well be the first step toward a debilitating, nation-wide
liquidity crisis. In the three weeks following the suspension of the Guandong concern’s
operations, several other ITICs have experienced a squeeze as nervous international creditors
have begun to refuse to “roll over” debt obligations coming due. This problem is exacerbated by
these Chinese institutions’ past affinity for borrowing short-term to finance long-term
infrastructure development projects — a problem bankers call a lack of “tenor matching.”

As international capital becomes harder to come by, one can expect more ITICs to hit the
wall on
their debt obligations. The next to go may be Fugian International Trust and Investment
Corporation, which the Financial Times yesterday reported is experiencing serious
liquidity
strains.⁽²⁾ As stated in a Wall Street Journal
editorial by Shan Li and Tian Zhu of yesterday, the
worse may be yet to come:

But with losses mounting and the ratio of non-performing bank
loans soaring, China now finds itself in a financial crisis.

Reviewing China Bonds

The repercussions of the growing financial distress of China’s ITICs may make themselves felt
first in the international debt and equity markets. As the Casey Institute has documented in the
past, the Chinese government and its extensive network of state-owned enterprises and banks
maintain a substantial presence on global bond markets.⁽³⁾
Specifically, these Chinese enterprises
and government-controlled entities have issued about 134 bonds in world markets since 1980
totaling roughly $25-26 billion. Of this total, some 66 have been dollar-denominated in the
estimated amount of $10.4 billion. In the past decade, GITIC has established a presence on the
U.S. bond market to the tune of roughly $400 million. The largest of these offerings was an
October 1996 bond led by Merrill Lynch for $200 million.

It is predictable that the political leadership in Beijing, anxious to preserve what remains of its
favorable image in world markets — will seek to distance itself from what is shaping up to be a
string of such defaults. Stand by to be told that these foreign borrowings by China’s ITICs have
been unauthorized “rogue” operations. After all, this euphemism has been routinely employed to
disavow obvious government connections to enterprises suspected (and in some cases, caught in
the act) of proliferating weapons of mass destruction and missile technology to pariah states.

Whatever technique is employed to obscure the full truth, the Chinese government
cannot afford
to be viewed by the markets as having detailed knowledge of GITIC’s foreign borrowing
activities and rapidly deteriorating financial status, as it could further soil its market
reputation.
Like the chief of police in “Casablanca,” the party line is sure to be that the PRC is
“shocked,
shocked” to discover that the nature and extent of its troubled ITICs’ problematic funding
practices.

The Rating Agencies Again Drop The Ball

Investors’ confidence can hardly have been enhanced by the performance of Moody’s and
other
rating services as the Chinese begin to experience widespread effects from the global financial
crisis. Consistent with the recent practice of several of these agencies — namely, that of
downgrading borrowers only when the whole world knows they are going belly-up — Moody’s
downgraded GITIC’s foreign debt last Friday, only days before the Guandong
concern’s bond
default. To its credit, Moody’s did, however, react to the GITIC collapse by down-grading
China’s largest investment trust company, China International Trust and Investment Corporation
(CITIC).⁽⁴⁾

This belated action may persuade investors already holding CITIC paper — or those
considering
the future purchase of its bonds — to evaluate the inadequacies of past CITIC prospectuses and
overall financial disclosure. Moreover, it would be a welcomed development if all of China’s
ITICs and so-called “red-chips” in Hong Kong and on the mainland could, at long last, receive the
kind of serious auditing that they have richly deserved, but never really received.

In a milestone of understatement, John Pinkel, head of China research at Merrill Lynch, stated
in
the New York Times article of yesterday: “I think that the Chinese government didn’t
do enough
to clarify the liabilities of these companies. But equally, many banks were seen to be imprudent in
their lending to offshore entities of Chinese organizations.” These remarks succinctly summarize
the two major themes to which the Casey Institute has seeking to draw attention since April 1997.

According to the Times, Pinkel went on to estimate that, “China’s total foreign
borrowers — by
provincial and municipal governments and by their affiliated companies — was $30
billion higher
than Beijing’s official number of $130 billion. GITIC alone may have total debts of
more than
$2 billion.” (Emphasis added). The point is that no one in the West has a precise figure for the
dimensions of GITIC’s financial morass, much less those of other ITICs or of China writ large. In
the end, the Chinese government may feel compelled to make GITIC’s foreign creditors whole —
lending new meaning to the banking term “Chinese clean-up.” It is certainly prudent, however, to
remain alert to the possibility that Beijing is testing the West to determine if it can avoid a further
drain on its partially-encumbered hard currency reserves.

The Bottom Line

The U.S. Congress needs to address the China financial situation in the immediate
post-election
period. It should make clear that it will not stand idly by while a Chinese financial crisis creeps
toward the wallets of U.S. taxpayers in the form of thinly-disguised bilateral or multilateral
bail-out schemes. Securities and Exchange Commission Chairman Arthur Levitt (not to mention
Treasury and Federal Reserve officials) should be called before the Senate and/or House Banking
Committee to offer an assessment of the Chinese financial situation and its potential impact on
American holders of Chinese bonds and equity issues.

In addition, Mr. Levitt’s organization should be given greater authority for monitoring and
reporting to relevant congressional committees. Such authority would have been mandated if
Capitol Hill had adopted “The U.S. Markets Security Act of 1997” (S.1315) during the
105^th
Congress.⁽⁵⁾ Given all that is at stake for U.S. and other
friendly nations — with respect to their
pension and mutual funds, insurance companies, corporations and even individuals — arising from
the multi-billion-dollar presence of Chinese corporations in the U.S. bond market, there
is no
time to waste securing more transparency regarding such capital flows and their national
security, as well as financial, implications.

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1. See the Casey Institute’s Perspective entitled
Casey Symposium On Asia Illuminates High
Stakes In Debate On Renewal Of M.F.N. For China ( href=”index.jsp?section=papers&code=97-R_86″>No. 97-R 86, 23 June 1997).
Incidentally, the same warnings have been in order — and expressed by the Casey Institute —
concerning certain Russian bonds (for example, those offered by Russia’s energy monopoly,
Gazprom).

2. Conservative estimates place China’s non-performing loan
portfolios at roughly 20% of the
country’s total outstanding debt. A recent article in the Economist cited individual
accounts as a
main source of banking sector solvency.

3. See the Center’s William J. Casey Institute
Perspective entitled, Dangerous Upshot of
Clinton-Gore’s China ‘Bonding’: Strategic Penetration of U.S. Investment Portfolios
(No. 97-C 47, 1 April 1997) and the Casey Institute
Press Releases entitled Insight Magazine Breaks the
Code: Chinese Penetration of U.S., Global Financial Markets Has Strategic
Implications (No.
97-R 60, 3 May 1997), and USA Today Illuminates Case For Urgent Action
To Halt Chinese
‘Bondage’ (No. 97-R 68, 16 May 1997).

4. See The Dog That Didn’t Bark: Moody’s, Et.Al. Fail
Investors In Asian Markets, Miss
Warning Signs In China And Russia (No. 97-C
200, 23 December 1997).

5. This bill was sponsored in the House by Rep. Gerald Solomon
(R-NY) and in the Senate by
Sen. Lauch Faircloth (R-NC).