China's Counterproductive Plan to Eliminate Bad Debt

Swaps don't have scale or address the problem's source.

Chinese People's Liberation Army Barracks Open Day
Photographer: Justin Chin/Bloomberg

China's latest remedy for the vast amount of souring corporate loans on its collective balance sheet turns an old maxim on its head: it promises short-term gain for longer-term pain.

Reuters initially reported that China's central bank was laying the framework for financial institutions to swap non-performing loans into equity stakes in those firms.

Turning debt positions into equity reduces the number of non-performing loans on banks' balance sheets, presumably giving them more room to finance the stimulus efforts that China hopes will boost economic activity. However, the subordinate position of equity relative to debt in the capital structure will cap how many bad loans that banks can make disappear—and the swaps that are carried out could end up worsening the problem China is trying to solve.

In some respects, this plan is a rehash of a measure deployed during China's banking crisis in the 1990s to address elevated levels of bad loans.

But in another light, it's also a continuation of a tactic that was not sufficiently used during China's parabolic equity rally in late 2014 and early 2015. At this time, FT Alphaville's Matthew Klein aptly wrote "This is nuts, but could it be helpful?" Quoting Chen Long of Gavekal Dragonomics, Klein highlighted that lofty share prices incented firms to substitute equity for debt financing, something that would also aid the Chinese leadership in some of its longer-term goals.

"As a result, corporate debt/equity ratios fall and the economy becomes—or should become—less dependent on debt financing, which moderates overall economic risk," Long observed. "A bull market will also allow Beijing to sell the shares of state-owned enterprises at higher prices, much as it did in 2007, which should facilitate state-owned enterprise reform."

On the surface, these debt-to-equity swaps look to be a win-win: banks have fewer non-performing loans on their books, and these former corporate debtors are no longer on the hook for obligations they've had trouble servicing, and have a more diverse financing base to boot.

But the deleterious impact these swaps have on banks' Tier-1 capital ratios will limit the extent to which non-performing loans can be reduced through this method.

"Banks are comfortable owning a new option in handling non-performing loans but we think it is unlikely to be of significant scale given there are limited ways of replenishing Tier-1 capital once depleted, with banks trading at 0.7 [times] price to book (capital raising has to be above 1.0 times)," wrote analysts at HSBC Bank PLC.

Analysts at The Goldman Sachs Group Inc. noted that the risk weight charge for equity investment ranges from 400 to 1,250 percent, compared to 100 percent for loans.

On the surface, it's difficult to discern the rationale for why the risk weight charge for souring loans would be so much lower than for equities even after taking the different places the two occupy in the capital structure into account. Given the dearth of corporate defaults in China, however, it seems eminently reasonable in this instance.

"We believe debt-to-equity swaps [DES] could modestly help address the non-performing loan issue if the following conditions are met: 1) DES is properly structured and priced i.e., pricing and deal structure are based on market terms reflecting investment risks and returns, 2) underlying business of troubled debtors is viable in the long run to allow for profitable disposal later on, 3) exit mechanism is in place to facilitate DES disposal including listing to public market and M&A," added analysts at Goldman Sachs.

Those are some pretty big ifs, as Goldman's team acknowledges. To the extent that these swaps can be carried out, they may in fact make the fundamental issue—immense private indebtedness—worse.

"However, we believe debt-to-equity swaps by banks, if allowed, may not become the main avenue for NPL disposal and the process needs to be carefully managed due to…potential moral hazard and dip in underwriting standard especially for state-owned enterprise loans," concludes Goldman's team.

The balance sheets of firms that have had troubling servicing obligations in the past will be bolstered through these swaps, making access to credit easier in the future. And banks that hold equity stakes in these firms are probably less likely to deny them any funds they might need in the future—and without insisting particularly onerous terms.

In isolation, therefore, these debt to equity swaps seem to perpetuate the dynamics that gave rise to China's private debt problem and hordes of zombie firms in the first place.

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