Can the new debt-to-equity swap effectively tackle China’s moral hazard?
Beijing’s new debt-to-equity swap programme has good intentions, but authorities’ reluctance to let market forces set the price could be a stumbling block
China’s latest draft rules for its debt-to-equity swap programme to clean up the country’s bad debt problem have appeared to show efforts in making the process more market-driven than government-determined.
The debt-to-equity swap market has been flourishing since its inception last year, with banks converting more than 1 trillion yuan (US$149.2 billion) of debt into stock holdings in more than 70 state-owned enterprises (SOEs), according to the National Development and Reform Commission (NDRC).
The State Council said it was forbidding “zombie enterprises” from participating, and only companies facing temporary difficulties would be allowed to exchange their debt for stakes. The swap programme was meant for banks to pick indebted but viable SOEs for restructuring through the replacement of new equity holders and management, in hopes to turn companies into profit-making entities.
However, some analysts are sceptical to whether the design of the controversial swap programme can indeed attract private capital to become new equity shareholders, a key ingredient needed to help turnaround ailing companies, especially when the government remains reluctant to let market forces set the price of the equity through the debt swaps.
Beijing may simply only be willing to replicate the results of its last swap attempt in 1999-2000 when it set up four asset management companies to bail out 1.4 trillion yuan of bad loans from state-owned banks. The exercise then successfully averted imminently significant crisis risks, despite creating moral hazard and deferring contagion risks into the long term, the analysts said.
“In China, political and social considerations can take on unusual importance, which can make bankruptcy, workout, or NPL investments extremely challenging,” Brock Silvers, managing director at Kaiyuan Capital said.
Even though the debt swap was helping corporates turn loans into equity, lowering their liability-to-asset ratio, it was sucking up banks’ capital while moral hazard remained, analysts said.
China’s corporate debt is about US$18 trillion, equal to 170 per cent of the country’s GDP, the Bank for International Settlements said last year, with the swap programme under the current form seen as unsustainable, unless a more comprehensive market-orientated solution is adopted.
Last week, the China Banking Regulatory Commission issued new guidelines that raises financial institutions’ shares in the units or subsidiaries that are created to handle the swap, to at least 50 per cent for three years after the debt-to-equity swap, from 5 per cent previously.
It was uncertain if the remaining 50 per cent will be taken up by the private sector investors – expected to help restructure the company, or just be sold to China’s four state-owned asset management companies, which typically hold distressed debt as passive investors as was the case in the 90s, said Iris Pang, Greater China economist at ING Bank.
Theoretically, the banks’ bigger stakeholding in the unit that handles the swap should incentivise them to choose the companies for restructuring and attract private sector investors looking for monetisation. That would be an improvement from the adverse selection process in the previous scheme that attracted the worse companies to default and initiate the debt swap as a way to get bailouts, Pang said.
But analysts cautioned that the programme was unlikely to be able to properly identify winning or losing companies as long as the equity pricing problem remained unresolved.
China’s practice of selling banks’ bad debt at face value and then swapping into non-performing loans (NPLs) for equity at the same value of the NPLs without discounts meant that SOEs and banks are unwilling to accept losses in government assets while private sector investors won’t be drawn to invest without a deep discount, BNP Paribas Asset management senior economist, Chi Lo said.
“Some brave investors will cherry pick, but overall demand from private capital will probably be less than robust,” said Kaiyuan’s Silvers.
Meanwhile, the debt swap also means banks’ capital adequacy ratio would need to rise to as high as 1,250 per cent after making the equity investments through the debt swap under current regulations, leaving them short of capital and possibly requiring the government to step in.
Moral hazard typically arises in such situations, when banks and companies get involved in risky business knowing that they are protected against the risk and that the private sector or the taxpayer will incur the cost in the future.
“As long as this bailout mindset overwhelms the pulse of market discipline, it will remain an obstacle to genuinely clean-up of the zombie firms and NPLs,” Chi said.