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China’s debt-to-equity swap plan may struggle to take off

The program will face significant challenges including stakeholder interest conflicts and finding new capital sourcing, analysts say

PUBLISHED : Wednesday, 31 August, 2016, 8:58am
UPDATED : Wednesday, 31 August, 2016, 10:51pm

China’s debt-to-equity swap plan, a renewed version of the tool the government used in 1999 to spin off bad debts from state-owned banks, will come into effect in September, official media reported on Monday.

But a conflict of interests between local and central governments, as well as between creditors and companies are likely to see the plan struggle to get off the ground, analysts said.

China Securities Journal quoted authorities on Monday saying the scheme, which is being prepared by the National Development and Reform Commission (NDRC), will begin as early as mid-September, though the amount, quota and criteria for participants remain unknown.

The term “debt-to-equity swap”, meaning to swap the debt banks hold in underperforming companies for stock holdings, was raised by China’s premier Li Keqiang during the National People’s Congress in March and was hailed as a market-oriented means to reduce China’s rising leverage in the corporate sector.

However, only one debt-to-equity swap has taken shape since Li’s statement. In late March, Bank of China converted a 2.75 billion yuan (US$3.2 billion) loan to Huarong Energy, a private-owned shipping manufacturer, into a 14 per cent equity holding in the company.

Some analysts, including an “authoritative person” quoted by People’s Daily in early May, have warned that the program should be applied very selectively, to prevent it being used as a way to save so-called zombie companies.

In late July, creditors turned down a debt-to-equity swap plan proposed by Dongbei Special Steel, owned by the Liaoning provincial government, after it defaulted on seven batches of debt worth more than 4.7 billion yuan this year, mainland media outlet Caijing reported.

Creditors were furious about delayed responses from the company and the local government. Many requested bankruptcy liquidation, mainland media reported.

Iris Pang, an analyst with Natixis, said: “The struggle between policy makers and the industry explains the relatively long waiting time for the first case in March to become a more generalised practise.

“Different entities have their own agendas. For most of the companies, the swap is more than acceptable because they get rid of the debt burden, and local governments are also supportive because keeping the big zombies alive would save them from addressing thorny issues including lay offs.”

But many banks are reluctant because an equity stake in a company facing difficulties may not be favourable, particularly as current rules require banks to set aside 1,250 per cent of the value as risk weight if they fail to dispose of the equity holding within two years, said Pang.

Jenny Huang, an analyst with Fitch Ratings said: “The central government had highlighted that the program is only applicable to viable companies facing short-term financial difficulties, while local governments may use it to shore up so-called zombie companies, many of whom are large local tax contributors, employers, and big debtors to local banks.

“This would hamper the progress of Beijing’s supply-side reform that focuses on cutting overcapacity and phasing out uncompetitive companies.”

Huang said in a note issued on Monday that the debt-to-equity program “will face significant challenges from stakeholder-interest misalignments and obstacles of new capital sourcing. ”

The note said: “For example, secured lenders may prefer straight liquidation or restructuring plans that result in as little haircut to their claims as possible when the recovery value of their underlying collateral is sufficient, while the company and local governments may push for renegotiation of the collateral package and large haircuts.

Sourcing new capital to fund the debt-for-equity swap with a reasonable risk-adjusted return prospect will be a big challenge
Jenny Huang, an analyst with Fitch Ratings

“Sourcing new capital to fund the debt-for-equity swap with a reasonable risk-adjusted return prospect will be a big challenge.”

Caixin reported that in a recent swap proposal made by Bohai Steel, Tianjin provincial government, social capital, and bank-issued wealth management products would be likely to contribute to a fund to purchase the company’s debt which gets converted into equity with a proposed annual return of just 3 per cent.

“We believe this level of return is likely to be too low to justify the risk, making it unappealing to social capital,” Huang wrote.

A review by the International Monetary Fund of the Chinese economy earlier this year concluded that corporate debt, which stood at around 145 per cent of GDP, remains a serious and growing problem and may spark a crisis if the government fails to tackle it.

According to the current regulations, Chinese commercial banks are prevented from investing in non-banking companies, although their subsidiaries can.

The central government set up four bad banks in 1999, includingChina Huarong, China Cinda, China Great Wall and China Orient, to lead the task of soaking up 1.4 trillion yuan in bad loans from the state-owned banks, through various means including debt-to-equity swaps.

Official numbers shows Chinese banks’ bad debts stood at 1.44 trillion yuan at the end of the second quarter. The non-performing loan ratio for Chinese commercial lenders stood at 1.75 per cent at the end of June.