Banking & Finance

Pass the parcel

China’s latest debt-for-equity swap scheme has its sceptics


Cinda seems set for another rescue mission

For nearly a week in the summer of 1999, senior officials from thousands of state firms queued up at the State Economic and Trade Commission’s main office in Beijing. The State Council had just announced a new policy allowing state banks to swap bad debt for equity stakes in ailing state-owned enterprises (SOEs).

SOE bosses from all over the country wanted a piece of the new programme. “Competition was very intense as everyone wanted to take part,” an official recalled in the Economic Observer this week. “However, only more competitive SOEs with stronger corporate governance stood a chance of being picked.”

The State Economic and Trade Commission eventually recommended 601 state firms and restructured debts worth Rmb460 billion. Many of the luckier firms survived the economic downturn following the 1998 Asian financial crisis.

However, the credit crunch contributed little to the financial health of the state banks. By 2003 the biggest banks were technically bankrupt with bad loan ratios surpassing 30%. So the country’s four major asset management companies (AMCs, or ‘bad banks’ in newspaper parlance) stepped in and took over a large chunk of their non-performing assets.

The restructuring rejuvenated the banking system but left the AMCs (which are financially backed by the Ministry of Finance, aka Chinese taxpayers) as shareholders in many malfunctioning state firms.

Take Cinda, one of the four AMCs. When it went public in Hong Kong in late 2013, it had an equity portfolio in 400 or so state firms. At best, Cinda will likely get back 25% on the dollar on its portfolio (see WiC220).

Earlier this month the State Council gave the green light to yet another debt-equity swap scheme. If history repeats itself, does that mean more problems for Chinese lenders, and a nightmare to come for the investors in AMCs such as Cinda and Huarong?

These are the questions that have been raised ever since the Chinese cabinet released its guidelines for the deleveraging of the Chinese financial system. The announcements came in two statements from the State Council, one on cutting corporate debt and the other on how state lenders should swap their non-performing loans for equity.

The State Council made plain its view that only companies with “temporary difficulties” but “long-term potential” will be eligible for the programme. Zombie SOEs, those only surviving on government subsidies, and companies with bad credit records will be forbidden from participating, the government says. “The scheme will not be a free lunch from the government and banks cannot be forced to conduct the swaps,” Xinhua insists.

There have been different projections on the true state of China’s indebtedness. According to the Bank for International Settlements, the country’s debt-to-GDP ratio was as high as 254.8% last year. Caixin Weekly, which cited undisclosed figures from the Chinese central bank, says that corporate debt amounts to roughly $18 trillion, or 160% of the Chinese economy.

“The State Council’s latest guidelines have made deleveraging SOEs a criterion in evaluating the performance of government officials,” Caixin Weekly reports.

Unlike the previous programme in 1999, banks cannot convert debt into equity directly this time. Instead the debt has to be transferred through an “execution agency”. As well as the AMCs, insurers and other financial institutions are being encouraged to serve as these agencies, raising funds from public investors (including selling bonds) to purchase the assets in question.

“All in all the central government wants to buy time for the banks and for the broader economic reforms,” a banking official told the Economic Observer.

This hugely ambitious process of balance sheet re-engineering is underway already. The country’s biggest tin producer and exporter, Yunnan Tin Group, sealed a debt-to-equity swap deal with China Construction Bank (CCB) on Sunday. The state lender agreed to convert about Rmb10 billion of Yunnan Tin’s debt into equity owned by a new fund. CCB itself will only make a small investment in the fund and the rest of the money will be raised from institutional investors, like the four AMCs, the pension funds and the National Social Security Fund.

More deals are set to follow. CCB said it had approached more than 50 companies that could convert debt to equity.

“Yunnan Tin could become the poster child for the Chinese government’s latest efforts to cut corporate leverage,” Caixin Weekly notes.

In fact Yunnan Tin was one of the previous beneficiaries of the debt-to-equity swap programme in 1999. Cinda and Huarong, both listed in Hong Kong, became shareholders as a result of the conversion. Both AMCs cashed out last year and made a return of almost 300% on their original investments.

That may sound like good going for some Chinese investors. But other observers are sceptical about the current plan, and the fact that a leading commodity producer has required not one but two bailouts in as many decades.

“Many people in China think the tool will turn bad debt into bad equity,” Xu Bin, professor of economics and finance at the China Europe International Business School in Shanghai, told the Wall Street Journal.

Foreign rating agencies also warn that the new rules allow the debt-to-equity swaps to be funded by “social capital” including mutual funds and wealth management products. The banks are tangled up in many of these asset classes too, so it isn’t clear whether they will retain a lot of their exposure to corporate debts through ownership structures that lack transparency. For example, the banks’ exposure to many of the troubled companies might simply move off-balance sheet, if bank-linked wealth management products are used to fund the equity swaps, said Fitch.

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