Banking & Finance

Enough policy tools, now it’s time for China to refine its approach on sorting bad debt

The debt for equity swap, along with other policies, will undergo further refinement this year as China tackles it bad debt problem

PUBLISHED : Sunday, 08 January, 2017, 4:45pm
UPDATED : Sunday, 08 January, 2017, 10:14pm

In 2016 Chinese policy makers rolled out a number of new initiatives to enable banks to deal with their bad debts, while offering further clarification on those that already exist. Analysts do not expect any significant further innovations to emerge in 2017, instead this year will be one for refining existing tools, while monitoring their effectiveness.

As the numbers of troubled loans in the system are expected to rise in 2017, the success or otherwise of banks’ and policy makers’ efforts to deal with the bad debts this year will offer a strong indication as to whether a major recapitalisation of the sector will be necessary. Regardless, however, the crunch point is unlikely to come this year.

“In 2016 we saw an array of tools emerge that banks can use to deal with their non performing loans,” said Liao Qiang senior director for financial institutions at S&P Global Ratings. “Banks can write off loans, can sell down bad debts to asset management companies and can conduct debt to equity swaps. I wouldn’t expect policy makers to roll out more tools this year.”

“Banks can write off loans, can sell down bad debts to asset management companies and can conduct debt to equity swaps. I wouldn’t expect policy makers to roll out more tools this year.”

Asset management companies, or AMCs, are companies that were created for the purpose of processing the bad debts on the books of Chinese banks. There are four large AMCs that were created in the late 1990s, the last time China’s banking sector ran into difficulties with debt. What’s new are the many regional AMCs to look after the debts of regional banks.

In a debt equity swap, banks sell loans that they have extended to companies which are now in difficulty to a special purpose vehicle, which then exchanges the loan for an equity stake in the troubled company.

“We have seen a lot of changes from the first debt for equity swap to where we are now,” said Alicia Garcia-Herrero, chief economist Asia Pacific at Natixis.

The first debt for equity swap in the current batch took place on March 8, 2016 and involved a loan from Bank of China to struggling shipping company Huarong Energy.

Bank of China bore much of the burden of the clean up in this case, though later swaps have seen the burden shared across China’s financial system more broadly.

“I would argue we are now at the stage of refining the swaps rather than innovating further,” said Garcia-Herrero.

Herrero said refinements are needed at special purpose vehicles that buy the debt from the banks at face value. While regulations stipulate that debt equity swaps cannot be used for so-called zombie companies, the loans may not be worth their face value, as, after all, the banks are seeking to sell them.

According to Natixis’ calculations, in 2016 debt equity swaps worth a combined 236 billion yuan were carried out, but this figure is equivalent to just 7 per cent of the total number of special mention loans in China’s banking system.

Special mention loans are those that the bank considers to be at risk but have not yet become non performing, and are a peculiarity of Chinese banks’ reporting procedure.

In the first nine months of 2016, China’s big five banks wrote off 274 billion yuan’s worth of bad debt.

As of the end of September, combined non performing loans and special mention loans combined made up 5.86 per cent of total lending extended in China. Non performing loans alone were 1.76 per cent.

“We expect the NPL and special mention loan ratios to deteriorate further in 2017,” Liang said.

“I wouldn’t expect the deterioration to be drastic as the Chinese economy showed signs of picking up in the fourth quarter, which will help.”

The question remains whether the existing tools at the disposal of banks and policy makers will be sufficient to process the current bad debts, and those that will emerge in 2017.

“The situation is worsening in terms of systemic risk, and debt equity swaps are transferring the risk from the banking sector to the shadow banking sector,” said Garcia-Hererro.

“Nonetheless it is too early to say that the system will collapse, nor do we see that happening in 2017.”