Debt equity swaps in China just a case of pass the parcel

Chinese authorities are reviving debt equity swaps to help process banks’ bad loans. However, the tangled web of the mainland financial system means that some of the risk associated with these bad debts has now passed to China’s ordinary householders, while other risks have ended up back with the banks, defeating the point of the exercise, say analysts.

In a debt equity swap, a bank that has lent to a company which is unable to repay the loan exchanges the loan for an equity stake in the distressed company.

In the late 1990s they were used as a tool to deal with debts Chinese banks issued to distressed companies, but this year they have started to be used again in the latest attempt by authorities and lenders to clean up banks’ balance sheets.

However, according to guidelines issued by the State Council in September, this time around banks are not allowed to hold the equity stake in the company directly, but rather have to sell the distressed debt to another entity. It is this entity which swaps the debt into equity, and all of China’s big five banks are creating subsidiaries for this purpose.

These subsidiaries can have a number of investors, including insurance companies, the national social security fund and individuals through wealth management products, according to a report from Natixis economists.

This meant “households have become an integral part of the clean-up process”, the economists said.

Households are exposed to the bad debts both passively via the national social security fund and by holding a policy with an insurance company that has invested in the fund which holds the bad equity, and more actively if the household invests in wealth management products which embed products issued by the fund.

If the distressed corporate is able to turn itself around successfully, then all is well for the household. The fund created to hold the equity can sell its stake on the open market for more than it paid to buy the bad debt from the bank, and the principal can be returned to investors who can pocket any dividends.

In the other scenario, however, which the Natixis economists describe as “more likely”, the distressed company is unable to turn itself around.

“Ultimate investors (including households) could suffer a loss on interest income as well as some capital loss,” they said.

However, there are a number of protections for the household, particularly for their investments via wealth management products, which are sold by banks.

“With wealth management products, the risk sits in a no man’s land, legally it is the investors on the hook, but the expectation from the market is that the banks who issue the products will stand behind them,” said Jack Yuan, an analyst at Fitch ratings.

According to Fitch calculations, in the first half of 2016 an average of 3,700 wealth management products were issued every week, but only one product issued by a domestic bank reported any form of loss.

This suggests that banks are covering the losses, and as such will end up exposed to struggling corporates, despite the debt equity swaps.

“The difference for the banks is that they get to move these troubled loans off-balance-sheet,” said Yuan.

In some ways this is good for the banks as their reported capital and leverage ratios don’t incorporate risk from wealth management products that they have sold, as legally – if not in reality – they are not responsible for them. Therefore, banks can use more of their capital for revenue generating, possibly risky activities.

As a way of dealing with risk in the system, however, it is rather less effective.