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China’s equity-swap tonic for toxic loans could make things worse for domestic banks

Analysts caution that Chinese banks could be saddled with low to zero yielding equity under the current proposal

PUBLISHED : Tuesday, 12 April, 2016, 1:24pm
UPDATED : Tuesday, 12 April, 2016, 1:32pm

Chinese banks are set to face multiple pressures under the coming debt-to-equity swaps (DES) despite the short-term benefit, analysts said.

“Bank’s ability to recover the money advanced will be more remote as a shareholder rather than as a lender,” Andrew Lam said, the director at accounting firm BDO Limited.

When a company goes into bankruptcy, lenders have priority status when it comes to repayment, while shareholders are lower down the totem pole when it comes to getting their investment back, the veteran accountant said.

“If these firms survive, there won’t be problems. But many Chinese firms have kept low efficiency with excess capacity for a long time, and should just shut down,” said Yao Wei, China economist at Societe Generale.

Chinese premier Li Keqiang said at the National People’s Congress in March that it may use “market forces” to implement debt-equity swaps (DES), which convert firms’ loans into equities held by banks, in a way that could deleverage the debt-heavy enterprises and reduce banks’ soaring bad loans as economic growth slows down.

Mainland media Caixin reported that a pilot DES plan totaling 1 trillion yuan (HK$1.2 trillion) could be officially announced in coming weeks and completed within three years. China Development Bank, Bank of China, Industrial and Commercial Bank of China and China Merchants Bank are likely among the selected participants.

“The capital amount, which is equal to 78.5 per cent of total net non-performing loans (NPLs) of all commercial banks in China by end 2015, should by all means alleviate the rising pressures on asset quality for banks for the moment,” China Merchants Securities said in a research report.

China’s economic slowdown has been reflected in a surge companies unable to meet loan payments, sending the percentage of Chinese bank loans classified as non performing to a 10-year high of 1.27 trillion yuan at the end of last year

The majority of these non-performing loans were related to industries suffering from overcapacity, including manufacturing, mining, and wholesaling sectors.

“One could argue that under the DES, the banks may not need to write off the loans concerned, and could recover the money later as a shareholder if the businesses recover. But this is by no means certain,” BDO’s Lam said.

Meanwhile, their liquidity may be adversely affected under the DES which freezes up part of their capital. The DES pilot plan could consume domestic banks’ capital, at least, a fourfold pace to general corporate loans, China Merchants Securities said.

If 1 trillion yuan of loans convert into equity, commercial banks’ core tier-1 capital adequacy ratio (CAR) should be dragged down by 29 basis points, although they reported a relatively high core tier-1 CAR of 10.91 per cent in 2015 versus 8.5 per cent required, according to China Merchants Securities research.

J.P. Morgan Asset Management Chief Market Strategist Asia Hui Tai said he had concerns that the asset swap programme could end up self defeating.

“Banks are supposed to be a distributor of capital, but the DES is to change the function and freeze up part of their capital,” Tai said.

Even though troubled firms will get a lifeline under the new programme, banks are likely to suffer as the equity holdings won’t provide income.

“It may be difficult for struggling businesses to pay dividends too, so the banks’ investments in such equities may have little return at least in the short to medium term,” Lam said.

It is also hard for banks to value and exit their equity holdings, especially from those non-listed companies, Macquarie Capital Limited analysts Larry Hu and Jerry Peng said in a research report.

China introduced a similar asset-swap scheme in the run up to the turn of the millennium. Between 1999 and 2000 China’s big four asset management companies (AMCs), including China Cinda Asset Management, China Huarong Asset Management, China Great Wall Asset Management, and China Orient Asset Management, were established in succession to take over bad debts from commercial banks.

The four AMCs digested 1.4 trillion yuan worth of bad debts, financed by issuance of financial bonds to those banks and borrowings from the People’s Bank of China, as well as 40 billion yuan capital injected by Ministry of Finance, according to the prospectus of Cinda, which became the first listed AMCs among the four in Hong Kong in 2013.

“The earlier [1999] DES was a better one. Banks removed the bad debts from their balance sheet permanently,” Societe Generale’s Yao said, “This time it seems that they want to convert the debts to equity when they are still on the banks’ balance sheet.”

Yao believes the government will stand at the ready to prevent any systematic risk in the banking industry if domestic lenders find it hard to absorb 1 trillion yuan in bad debt.

Both debt-heavy state-owned enterprises and local governments who collect taxes are winners of DES. But for banks, the game is complicated and debate with other parts would be intense, Macquarie’s Hu and Peng said.

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