Many of the best horror stories rely on a very simple premise. Set it in an isolated country house (preferably haunted), invite some troublesome guests and then kill them off one by one. The 1961 comedy horror film What a Carve Up is built around just such a plot.
It also makes a very fitting title for the horror show currently facing the People’s Bank of China (PBoC) as it tries to carve up non-performing loans (NPLs) and dispose of them. It forms part of a clean-up trilogy for the central bank, which in 1999 carved out Rmb1.4 trillion ($215 billion) worth of NPLs to four newly created Asset Management Companies (AMCs) and a further Rmb1.2 trillion over the course of 2004 and 2005.
The new NPLs have worked their way through the banking system following the global financial crisis of 2008 and the credit binge that followed. On the surface, the figures do not appear that alarming. At the end of 2015, NPLs stood at Rmb1.27 trillion. While this is a similar figure to previous carve-outs, the overall bad debt ratio is just 1.67%, since bank balance sheets are a lot bigger now than a decade ago.
However, with banks’ stock prices trading below book value, investors have priced in NPLs peaking at more like 7%. In response, the PBoC is giving the banks more options to bolster their balance sheets.
Alongside write-offs and AMC sales, it is also piloting asset-backed securities (ABS) and potential debt-for-equity swaps – as well as a reduction in minimum provisioning levels to boost profitability and encourage banks to come clean about the true extent of their NPLs. A Rmb50 billion ABS pilot scheme repackaging the bad loans of the big four state-owned banks plus BoCom and China Merchants Bank was launched just after Christmas.
However, Bloomberg suggests other smaller banks are wary about investing in the ABS plan. “It would be too risky for us,” says Lin Yijian from Guangzhou Rural Commercial Bank. Song Qiuhong from Guangdong Shunde Rural Commercial Bank also tells Bloomberg that other banks may not be keen, but believes the product may attract wealth management investors looking for higher yields.
Banks themselves may also be allowed to engage in debt-for-equity swaps, thanks to new rules being drafted by the PBoC. Under Article 43 of China’s Commercial Banking Law, financial institutions are not allowed to take equity stakes in non-financial institutions.
However, this kind of debt restructuring is not without precedent. Banks ended up holding 0.15% of their total assets in debt-for-equity swap form in the late 1990s after being granted State Council exemption during the first NPL crisis. These stakes were subsequently unwound before each of the state-owned banks listed.
Other analysts says the swaps will lead to weaker capital adequacy ratios since publicly-traded equities carry a 290% risk weighting (and unlisted equity 370%), compared to the much lower 100% for a new loan and up to 250% risk weighting for an NPL.
However, CICC thinks it is a good idea and believes the PBoC is also considering a structure similar to Sweden’s good bank/bad bank model. Banks will sell assets at book value to new AMCs, which – being legally separate – will not impact capital. These will then swap debt (at appraised value) for equity.
The test case may be Huarong Energy (formerly Rongsheng Heavy Industries). Last month, it agreed to issue nearly 90% of its equity to creditor banks led by Bank of China, offsetting Rmb17.8 billion in debt.
WiC has written many times about Rongsheng’s colourful owner, Zhang Zhirong, who has tried to ride out the storm in the global shipbuilding industry by providing up-front financing for companies no longer able to afford orders. However, he failed to take into account the length of the downturn, which saw the Baltic Dry Index fall from a high of 11,793 in 2008 to 290 this February.
One seasoned foreign banker says he’s against the use of debt-for-equity swaps in China. He reasons that the banks involved will have no power to turn around the troubled companies. And when the flaky firms’ financial problems worsen further, the banks will find their equity is worthless.
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