Of all China’s worries, high and rising debt levels have emerged as the biggest challenge facing the world’s second largest economy.

Under the so-called debt-to-equity swap reform, launched last month, the government last week approved the state-owned metals trader Sinosteel to swap its 27 billion yuan of debt for equity convertible bonds.

Leverage in China has soared to alarming levels, with overall debt swelling to as high as 280 per cent of GDP last year. While estimates of the leverage ratio vary, there is a strong consensus that the corporate sector, especially bloated state-owned enterprises (SOEs), are the riskiest borrowers.

State-owned Sinosteel to swap 27 billion yuan worth of debt for convertible bonds

Official statistics showed that SOEs had total liabilities of 83.74 trillion yuan by the end of July, up 17.6 per cent on the year and 66.2 per cent of its total assets.

State-owned banks’ bad debts stood at 1.44 trillion yuan at the end of the second quarter. The official non-performing loan ratio – the share of total loans which are in default or close to default – for Chinese commercial lenders stood at 1.75 per cent at the end of June. But economists suggest a higher figure might be more accurate.

French investment bank Societe Generale warned that the SOE debt restructuring could jeopardise more than half of the state-owned banks’ capital base. If that happened quickly, it would almost certainly plunge the country’s banking sector into a systemic crisis.

In the 1990s, then premier Zhu Rongji launched his attempt at SOE reforms. They eventually pushed state-owned banks’ NPL ratios to between 30 and 50 per cent, rendering the entire banking system insolvent.

Earlier this year, the ratings agency Moody’s downgraded the Chinese government’s credit rating, citing the “contingent liabilities” of the SOEs as one of its reasons.

China’s economy has a host of problems. But the biggest is that SOEs – chiefly blamed for the significant and persistent slowdown of growth in the past few years – are making way more stuff than the market wants.

Sinosteel to try debt-to-equity swap to restructure loans

Closing down these Soviet-style hangovers, with bigger liabilities than assets, would solve the problem, instead of helping them survive on cash injections, which will further harm the economy.

SOEs are wasting everything from human resources to funds; spurring indebtedness; and stifling corporate creativity and business innovation. The whole thing makes “rebalancing” toward a sustainable consumption- and innovation-driven economic model near-impossible.

The party leadership pledged in 2013 to fully embrace a free market, yet its latest plan aims to boost the public sector at the expense of overall economic health and public interests.

This restructure simply shifts the risk to the capital markets by converting the bad debt into bad equity. Many innocent small investors will be induced to buy these equity convertible bonds, which are liabilities not assets. Some business officials might hope the ploy can boost SOEs’ performance, at least on paper.

China's watchdogs step in to avert Sinosteel bond default

But the most fundamental restructure is to build a marketplace open for fair competition among all, which requires the government to completely scrap SOEs’ political privileges and their monopoly status. The best way to truly and fully embrace a free market is to allow those losing SOEs to sink naturally, in accordance with the rules of free market economics.

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But something like that would inevitably undermine the party’s grip on the nation. Then, the ruling Communist Party would have to face the key challenge to the future of Chinese economy: will it be willing to implement reforms that threaten its own power?

Cary Huang, a senior writer with the South China Morning Post, has been a senior editor and China affairs columnist since the early 1990s