State-owned Enterprises

How a bloated Chinese state firm hopes to rise again from under a mountain of debt

Yunnan Tin is banking on another massive debt-to-equity swap to secure its future but many observers aren’t buying the idea

PUBLISHED : Thursday, 20 October, 2016, 10:30am
UPDATED : Thursday, 20 October, 2016, 11:25pm

About two decades ago, the world’s biggest tin miner was rescued from the brink of bankruptcy and brought back to life.

The Yunnan Tin Company’s bad debts to state banks were hived off to two state-owned asset management arms, which became cornerstone investors in the new Yunnan Tin Group through a debt-to-equity swap deal.

The rescue was part of a massive bailout programme that China started in the late 1990s to clean the debt slate and allow state enterprises to borrow and expand again.

Backed by local authorities and favoured by state banks, Yunnan Tin and thousands of others like it grew, ushering in an era that became known as the “advance of the state economy and retreat of private economy”.

Yunnan Tin’s debt-for-equity swap raises market concerns

But many of those state companies are again in trouble, struggling under the crushing weight of borrowings they will never be able to repay.

Back, too, are debt-to-equity swaps as a remedy for the financial problem.

Observers are warning, though, that the deals are doomed to failure.

Yunnan Tin expanded through aggressive mergers to become a 50 billion yuan (HK$57.56 billion) behemoth with 95 direct subsidiaries.

Others like it included the struggling Longmay Group in Heilongjiang – which was created to run all state-owned coal operations in the province – and Dongbei Special Steel in Liaoning, the provincial government’s arm in managing the local steel industry.

Debts at companies such as Yunnan Tin have helped to bloat China’s corporate debt level to 169 per cent of its economy, with the International Monetary Fund warning of a debt crisis if the US$18 trillion debt mountain is not handled properly.

It’s a major concern and one that even China’s positive-looking economic data can’t mask. China’s statistics agency said the country’s gross domestic product expanded 6.7 per cent in the third quarter, the same increase as in the previous two quarters, in a sign of growth stabilisation. But a recovery engineered by government spending and property investment can, at best, only ease fears of an imminent hard-landing – while the debt bomb clock continues to tick.

Major Chinese state steel maker starts bankruptcy process after failed debt-to-equity attempt

Henry Paulson, a former US Treasury secretary with broad experience with China’s ruling elites, says state-sector debt is a major medium-term challenge for the leadership.

To get some of these done will be very difficult and it’s going to take strong political will, particularly dealing with state-owned enterprises
Henry Paulson, former US treasury secretary

“The reforms [Xi] has outlined are the right reforms,” Paulson said. “But to get some of these done will be very difficult and it’s going to take strong political will, particularly dealing with state-owned enterprises.”

On the one hand, the government cannot afford to let state firms go bust, as many are virtual mini-kingdoms that look after towns and cities. Yunnan Tin’s website says the company manages an area of 200 sq km and a population of 150,000 people.

But allowing ailing state-owned enterprises to survive means lending them more money to repay old debts – Yunnan Tin recorded a 3.2 billion yuan loss last year, double its 1.4 billion yuan loss in 2014, according to the financial statement released by its listed subsidiary.

Chinese Premier Li Keqiang is trying to use debt-to-equity swaps, albeit market-oriented deals, to solve the problem, but the proposal has caused concerns it could be misused to offer another “free lunch” to China’s loss-making state enterprises.

In a May 9 People’s Daily article, an authoritative figure, whom many believed to be President Xi Jinping’s top economic adviser Liu He, said any easy resort to debt-to-equity swaps would be “costly”, “self-deceiving” and become a large burden.

China needs more economic reformers to take up top jobs: Henry Paulson

So, when China Construction Bank (CCB), the nation’s second largest lender which shifted bad accounts to state-run asset management company China Cinda in 1999, agreed on Sunday to a debt-to-equity pact worth almost 5 billion yuan with Yunnan Tin Group, the news was received with joy by Yunnan Tin investors but with frowns by researchers.

The share price of Yunnan Tin’s listed vehicle jumped 10 per cent on Monday after CCB announced the deal, which is part of a 10 billion yuan package to bail out Yunnan Tin.

Compared with the late 1990s when public funds were used directly, the swap is cloaked in a “market-oriented” arrangement with a rescue fund, and CCB is wooing other investors, mainly state-owned financial institutions with close ties to CCB, to buy into the fund that boasts an expected annual return of up to 15 per cent. While there’s no absolute guarantee of such returns, Yunnan Tin promised it would make a 2.3 billion yuan profit by 2020, but did not specify how, according to a statement from CCB.

New rule on debt-for-equity adds risk to process, warn analysts

The deal followed a similar plan by the bank to raise 24 billion yuan for a fund to write off debts at Wuhan Iron & Steel Group, a steelmaker that has been taken over by Baosteel Group. SinoSteel, a state-owned steel material trading conglomerate, is working with creditors to swap its billions of yuan in debt into equity. A similar debt-to-equity swap at Dongbei Special Steel failed when banks refused to accept the terms offered by the Liaoning government.

The purpose is to make state-owned enterprises bigger and whitewash banks’ deteriorating asset quality
Hu Xingdou, Beijing Institute of Technology

Hu Xingdou, an economist at the Beijing Institute of Technology, said such swaps are doomed to fail and amplified the “moral hazard” in the China state sector.

“The purpose is to make state-owned enterprises bigger and whitewash banks’ deteriorating asset quality,” Hu said.

“The practice, which is totally against basic market rules, will lead to a distorted market which is dominated by inefficient state businesses, repeating the history of when China launched the policy in the late 1990s.”

Andrew Collier, managing director of Orient Capital Research, said the bailout plans “unfortunately do nothing to forward the progress of supply-side reform requested by Xi Jinping”.

It’s unlikely that investors would be interested in a company in an industry with overcapacity
Andrew Collier, Orient Capital Research

“It’s unlikely that investors would be interested in a company in an industry with overcapacity,” Collier said. The deals “just delay the inevitable reductions in capacity that China needs to undertake to improve the efficient use of capital”.

According to a research paper by a group led by He Fan, an economist at the Chongyang Institute for Financial Studies, a Renmin University think tank, and formerly a researcher with the Chinese Academy of Social Sciences, swap deals should not be seen as a primary solution for debt problems.

“No Chinese banks or third-party institutions are able to undertake such huge swaps partly as the steel industry alone had 1.68 trillion yuan of debts needing to be swapped,” the paper said.

“The swap should not become a major means for reducing corporate leverage.”

A buy-back option for Yunnan Tin suggests local governments could remain on the hook for any ultimate losses if swaps don’t work out, according to a BofA Merrill Lynch Global Research report.

“As a result, more state-owned enterprise debt may have to be nationalised at a certain point. This may mean that the central bank burden as the lender of last resort may rise, putting additional pressure on the yuan,” the investment bank’s analysts, led by head of China Equity Strategy David Cui, said in the report.