HONG KONG (Reuters Breakingviews) - China’s debt-to-equity swap plan is a complicated attempt to carry out a corporate turnaround in the People’s Republic. The government-backed scheme, launched in mid-2016, is designed to ease the burden on the country’s heavily indebted state-owned enterprises. By mid-January, banks and borrowers had agreed to convert loans worth approximately 300 billion yuan ($43.5 billion) into shares, according to a Reuters analysis.
The programme faces major challenges, however. Most of the companies involved are troubled miners and steelmakers, which could be beyond salvation unless China’s state-led system forces through tough changes.
How big is the problem?
Chinese companies have borrowed heavily since the 2008 financial crisis, with state-owned enterprises leading the splurge. These inefficient groups now owe more than half the country’s corporate debt, according to the International Monetary Fund. Total credit to non-financial corporations reached $17.9 trillion at the end of the second quarter of 2016, according to the Bank for International Settlements, almost twice what it was in 2011 and equivalent to nearly 168 percent of GDP. Some independent analysts think as many as one in five bank loans could be sour or souring - far higher than official figures.
Writing down the loans could tip companies into bankruptcy and force banks to recognise huge losses. The debt-to-equity swap is another way to tackle the problem. It could also help regulators achieve their goal of developing a local market for distressed debt.
(Reuters graphic: China's non-performing loans: reut.rs/2miupdc)
Hasn’t China tried this before?
Sort of. When the People’s Republic last cleaned up its banks in the late 1990s, the central government shifted dodgy loans into specially created “bad banks” which managed the dodgy credits. The recovery effort was aided by China’s rapid growth; the economy effectively outgrew the debt. Today, however, the amount of outstanding credit is much larger, while the economy is expanding at its slowest rate in decades.
How far will it go?
Chinese regulators insist the scheme is not a system-wide bailout. The goal is to help selected companies – mainly those battered by the selloff in commodities - get over a temporary crunch. Easing pressure on cash flow gives the companies time to turn themselves around. Avoiding bankruptcy also averts bond defaults that could rattle financial markets, and mass layoffs that might lead to protests.
One Chinese official initially forecast that the swap programme could reach 100 billion yuan: the number is already three times higher than that. Natixis economists estimate as much as 3.1 trillion yuan could be swapped.
For an example, look at Yunnan Tin. The world’s largest tin producer, which had over 15,000 employees at the end of 2015, lost nearly 6 billion yuan over the three years ending 2015. A revival of global commodity prices helped it return to the black in the third quarter of 2016, but it still struggles with staggering debt service obligations. It was one of the first participants in the programme in October, swapping some 10 billion yuan worth of loans from China Construction Bank into shares.
How does the scheme work?
Creditors exchange their debt for shares in the troubled company. But Chinese banks don’t want to hold big equity stakes on their balance sheets because these assets attract a big capital charge.
That is why lenders sell the struggling company’s loans to a special-purpose vehicle, known as an asset-management company, before carrying out the swap. The state-owned company reduces its debt burden, and the bank clears a dodgy credit from its books.
So far, the banks have avoided further writedowns by transferring their loans at par value. This leaves the AMCs – some of which have been set up by the bank - on the hook for further losses.
Banks can help transactions along by providing credit to the AMCs. But in order to ensure that the exposure is transferred off lenders’ books, the AMC must also raise funds from other investors. These could include other banks, pension funds, other AMCs and even wealthy individuals.
Regulators may even permit the AMC to issue special debt-equity swap bonds which could be sold in the wider market.
If the companies involved recover, they will buy back the shares from the AMC after five years at a premium - although this may not be a hard rule. In that scenario, the securities issued in the swap would be more like subordinated bonds or deferred-interest loans than equity. So far, however, few concrete details of how the shares have been priced or who has bought them have been published.
Will it help companies recover?
Many state-owned companies are saddled with irrational cost structures. Some still run loss-making schools and hospitals, a holdover from the days when China was a command economy. Others dabble in real estate, financial intermediation or other non-core business lines.
The challenge, though, will be disciplining companies unused to discipline, especially if local governments resist efforts to make them streamline. It’s unclear whether the AMCs will have any influence over decision making. The danger is that companies see debt relief as a signal to go on another borrowing spree.
Following Yunnan Tin’s debt exchange, the company’s listed unit announced a 2.4 billion yuan private placement in December and plans to invest 2.6 billion yuan in expanding mining output the following month. This seems aggressive for what remains an indebted company operating in an industry suffering from overcapacity.
The biggest shortage may be human resources. Thanks to a long-standing tradition of bailouts and government intervention, China has never had much demand for specialists with experience of turning around state-owned firms.
Who ends up holding the risk if things go wrong?
One worry is that banks invest in AMCs set up by other lenders, or buy their swap-backed bonds. This would simulate a cleanup but actually just redistribute the risk around the banking system. Companies would have little incentive to improve efficiency. Meanwhile banks - and the country’s taxpayers – would still be on the hook.
Few believe the government will actually let troubled state companies go bankrupt even if the swap fails to restore them to health. Similarly, it seems unlikely that Beijing will let investors in the AMCs take a bath. Seen in this light, China’s swap scheme could be more like a punt on a taxpayer-financed bank bailout than an honest bet on a resurrection of state-owned companies.
The views expressed in this article are not those of Reuters News.
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