Beijing’s debt-for-equity rules pose more questions than answers, Fitch says
The programme designed to cut dangerous levels of corporate leverage fails to address ‘zombie’ firms
New official guidelines for a debt-for-equity swap programme designed as part of the solution to China’s alarmingly high leverage provide more questions than answers, according to analysts at Fitch.
First proposed by Premier Li Keqiang in March this year, the debt-for-equity scheme is viewed as a priority for Chinese leaders to bring down soaring leverage in the corporate sector, which hit 169 per cent of gross domestic product in the first quarter.
While debt-for-equity swaps could act as a relatively growth-friendly route to corporate deleveraging, the plan is fraught with implementation risks, said Fitch in a report.
Under the framework, released by the State Council last month, banks will transfer non-performing loans to “implementing agencies” that will then convert them into equity. The conversion price is supposed to be “market-oriented” and negotiated by banks, investors, debtors and the implementing agencies.
Banks will not be forced into transactions, and firms deemed to have no viable future will not be allowed to participate.
However, in practice, the government’s heavy influence in the financial sector could easily compromise the market-based pricing mechanism, the credit ratings agency warns.
In addition, banks could end up retaining their exposure to corporates through complicated ownership and transaction structures that lack transparency.
In particular, banks’ exposure might simply shift off their balance sheets if bank-linked wealth management products (WMPs) are used to fund the swaps, Fitch points out.
These concerns have not been eased by the earliest examples of the programme in action.
China Construction Bank (CCB) has established several funds under its subsidiary that will take over the loans of Yunnan Tin Group and Wuhan Iron & Steel Group from other banks, before converting them into equity. The loans transferred to the funds managed by CCB’s subsidiary were priced at face value, reflecting their classification as normal loans.
“We believes the loan-classification standards are not necessarily comparable with those in international markets, in part because they may not be applied consistently and uniformly across all banks in China,” said Dan Martin, a senior analyst at Fitch Wire, a commentary published by the agency.
This raises doubts about whether the loan valuation would truly reflect the underlying creditworthiness of the borrower and if it is really being determined by market forces.
Another big worry is that CCB may be leaning on WMPs to fund the deals, and there is a risk that some retail investors may become exposed.
Fitch analysts said that even if future debt-for-equity swaps avoid some of these problems, the exclusion of “zombie” firms from the scheme means that it is not intended to solve the biggest risks to asset quality facing the banks.
Furthermore, it will not deal with the biggest problem of debt residing with zombie companies even if the worst pitfalls are avoided, said the rating agency.
“Government has given little indication of how it will deal with the debt of zombies,” said Martin in the report.
The banks will still be left with exposure to the most troubled companies, which make up a large segment of the corporate debt market.
Any meaningful solution is likely to take several years to implement, and is likely to require heavy bank losses and recapitalisation by the central government, said the rating agency.