Chinese premier Zhu Rongji had been slowly drawing the net around the country's second biggest investment and trust company long before the outside world or indeed the company's own executives knew what was happening. He sent trusted aides to Guangdong where they worked quietly for months to flush out financial irregularities and clean up the scandal-ridden province. Their investigations led to the shutdown of Guangdong International Trust and Investment Company (Gitic).
The move caught the market by surprise. The company was considered quasi-sovereign risk. It was number two among the 240 privileged "merchant banks" or trust and investment companies (itics) which had been set up by local governments with the blessing of Beijing to tap overseas markets for capital for the country's modernization programme.
Not only was Gitic the flagship fund-raiser for China's richest and fastest growing province, it also had a high profile among international bankers. Thus, although signs of serious problems had been emerging, including a top management reshuffle several months ago, few expected Beijing to take the drastic step of closing it down. But when Gitic ran short of funds to meet payment on a debt of about $700 million, the Guangdong authorities were not permitted to use provincial funds to keep their flagship afloat. Its executives were told of Beijing's decision just as they were about to go home to celebrate the Chinese mid-autumn festival on October 5.
Playing the key role in Gitic's demise was Zhu himself. The iron-faced premier so called for his no-nonsense approach took a personal decision to close down the institution. He reportedly told Hong Kong's chief executive Tung Chee-hwa: "The Gitic incident is not such a big deal ... After closing down unsound enterprises, the financial market will become healthier, won't it?" Chinese bankers noted that the closure did not even rate a so-called red-bar edict from the state council (a document issued by China's cabinet only for major government decisions).
The country's top leaders had long wanted to bring the wayward province to heel. Lax regulation over the past decade has bred in Guangdong a disregard for rules and a perceived disrespect for the central government. Zhu started his crackdown with two key appointments earlier this year: Wang Qishan, former head of the Construction Bank and an alternate member of the Communist Party's powerful central committee, was named executive vice-governor of Guangdong; and Xiao Gang, former head of the central bank's capital management in Beijing, was given charge of the central bank branch in Guangdong. Later, an inspection team led by state councillor "iron lady" Wu Yi was dispatched to dig deeper into the problems.
It was not an easy task - not least because Guangdong officials, while effusively polite, were generally uncooperative. Nor did it help that Beijing's men do not speak much Cantonese, the local dialect. Insiders say that local officials would whisper to each other in Cantonese during meetings, much to the annoyance of Wang, the main troubleshooter. There is a saying in the recalcitrant province: "What Beijing proposes, Guangdong disposes." Some 18 months ago, Gitic ignored the disapproval of the China Securities Regulatory Commission, and listed its subsidiary, Gitic Enterprises, on the Hong Kong stock exchange. The authorities were said to have been furious.
This year, Beijing meant business. Wang set up a team of young pro-Beijing supporters to investigate Gitic and other suspect firms. Initial estimates show that non-performing loans in Guangdong came to about Rmb100 billion ($12 billion) - the highest of any province and accounting for some 5% of the country's bad debts as of the first quarter of this year. Gitic alone owes international investors more than $2 billion.
Guangdong officials fought hard to keep Gitic's doors open. Governor Li Ruihua, sensing the way the wind was blowing, quickly put together a bail-out package worth tens of billions of renminbi. This was followed by what the local media dubbed as "marathon lobbying trips" to Beijing by Guangdong's communist party boss Li Changchun and his predecessor Xie Fei to persuade Zhu to change his mind and to allow the local government to bail out Gitic. All was to no avail.
Foreign bankers took the news with a mixture of disbelief and anxiety - disbelief that the authorities would risk damaging overseas confidence in the country's fund-raising vehicles and anxiety over whether their loans would be repaid.
Foreign bankers and investors sometimes provided loans based on only the flimsiest of information. Evidence of government patronage was often good enough. One story has it that Gitic officials, during initial loan talks with a foreign bank, thought it acceptable to provide their would-be lender with nothing more than a copy of its 25-page annual report.
Standard Chartered Bank group chief executive Rana Talwar has expresses confidence in Beijing's handling of the issue. But then all of its exposure in China is registered with the State Administration of Foreign Exchange (SAFE). Beijing has said that it will honour registered debt but that it has no legal obligation to honour "unregistered" transactions (deals which had not complied fully with SAFE formalities). Banks which had overlooked this legal documentation are now fretting. Talwar, who saw the premier in October when the bank held a board meeting in Beijing, says: "The issue is a complex one. We advised them [the Beijing authorities] to take into account all the consequences of their actions. They wouldn't want to see funds dry up to the good companies."
Fraser White, a partner of the law firm Clifford Chance in Shanghai, points out that registering short-term debt of less than a year would be Gitic's responsibility. It is only for medium-term debt that the market practice is to ask for proof of registration. "Foreign banks have not been entirely foolish in their dealings with Gitic," he says. "They were just trying to be business-friendly." But Qu Hongbin, an economist with Dresdner Kleinwort Benson in Hong Kong, takes a different view. "Banks should do their homework," he cautions. "China has capital control. This is not new. Borrowings must have government approval."
The biggest itic of them all, China International Trust and Investment Company (Citic), plays down the importance of the Gitic closure. Norman Li, senior vice-president of Citic Ka Wah Bank, sees it as a positive development. "Many itics are not healthy," he says. "They should be cleaned up." He points out that Citic Ka Wah actually has excess liquidity and that all its financial benchmarks are better than the industry average. Its capital-adequacy ratio is more than 20% and the loans-to-deposit ratio is 70%. The main impact on the bank of the Gitic closure, he says, is that the telephone hasn't stopped ringing with calls from fund managers and news reporters.
The full extent of the Gitic problem will not be known until January 6, the deadline for claims. But many banks and rating agencies are already taking a second look at the fundamentals of lending to China. There used to be a belief that some borrowers have quasi-sovereign status. Now foreign bankers are looking more carefully at credit quality. They will ask for proof of loan registration. They will no longer play around with structures to avoid registration and deals with state-related financial institutions will no longer be automatically considered guaranteed.
Managing director Paul Coughlin of rating agency Standard & Poor's says: "A key part in assessing the standing of the itics was the strength of the parents. With Beijing forbidding Guangdong from injecting fresh capital into Gitic, the relationship with the parent is less reliable than originally thought."
A source at the Bank of China explains the Gitic closure as the resolve of the central government to clean up the financial irregularities which had brought calamity to the rest of the region. He says: "The central government used to take responsibility for everything. Now, it is up to market forces. The closure of Gitic is meant as a message to institutions that lend to China that creditworthiness is to be found in the bottom line, the balance sheet, not the political backers. Beijing is attempting to remove grey areas in lending by taking a tough line on Gitic." Pauline Loong