China's Large Banks Wary on Li Keqiang's Plan for Bad Loans

  • Higher risk weights for equity stakes would weaken banks
  • Premier Li plans to use swaps to cut leverage, defuse risks

China’s proposal to deal with a potential bad-loan crisis by having banks convert their soured debt into equity is meeting with unexpected resistance from some of the biggest potential beneficiaries of the plan -- the country’s large banks.

QuickTake China's Debt Bomb

Asked about the plan at the Boao Forum last week, China Construction Bank Corp. Chairman Wang Hongzhang said he needs to think of his shareholders and wouldn’t want to see a plan that simply converted "bad debt into bad equity."

China Citic Bank Corp.’s Vice President Sun Deshun said at a press conference last week that any compulsory conversion of debt into equity would have to be capped. And Bank of China Ltd. Chairman Tian Guoli said in Boao that it’s "hard to evaluate" how effective debt-equity swaps will be, as so much has changed in China since the tool was used to bail out the banking system during a previous crisis in the late 1990s.

Behind the caution is a lack of clarity about how exactly the government will proceed with the conversion of up to 1.27 trillion yuan ($195 billion) of bad debt owed to the banks mostly by the country’s lumbering state-owned enterprises, and -- crucially -- about the level of support that will be available from the state. Bank of Communications Co., the first of China’s large banks to report 2015 earnings, said Tuesday it nearly doubled its bad-debt provisions in the fourth quarter of last year to 7.5 billion yuan.

Government backing

Without backing from the government, in the form of cash injections or easier capital rules for the banks, any debt-equity swaps would simply shift the bad-loan problem from the SOEs to the banks, with potentially disastrous consequences for the stability of the nation’s lenders. On the other hand it will be politically impossible to repeat the approach used in 1999 and again in 2004, when Chinese taxpayers effectively underwrote the bailouts, leaving the banks unscathed.

"You can’t kill three birds with one stone," said Mu Hua, a Guangzhou-based analyst at Guangfa Securities Co., referring to the need to balance the need to fix bank and SOE bad loans while protecting the interests of Chinese taxpayers. "Voluntary swaps won’t scale up unless the government offers enough incentive, such as lowering the risk weighting or setting up a platform for banks to dump the stakes."

The discussion of debt-equity swaps comes as China’s policymakers scramble for ways to cut corporate leverage that has climbed to a record high, and to clean up the mounting tally of bad loans on the banks’ books. Premier Li Keqiang said at the National People’s Congress earlier this month that the country may use the swaps to cut the leverage ratio of Chinese companies and to mitigate financial risks.

Under current regulations, banks face a punitive risk weighting of 1,250 percent for any equity they hold in industrial or commercial companies, though the amount of capital they have to hold drops to 400 percent of the value of the assets if they obtain special approval from the State Council. Even at the lower rate, it’s well above the 250 percent weighting for bad loans, meaning that banks would have to raise large amounts of extra capital if they swap SOE debt for equity on any scale.

"China banks’ balance sheets are not set up well to hold onto large amount of equities in industrial firms, which is why the CBRC is cautious and banks hardly hold any equities," said Matthew Smith, a Shanghai-based analyst at Macquarie Group Ltd. "If that’s the part one of a longer-term game to providing some relief to the distressed borrowers, the banks are not going to end up holding onto the swapped equity. There has to be some platform to offload this stuff."

Previous Bailouts

In 1999, government support came in the form of four special asset-management firms, which were set up with taxpayers’ money to buy about 1.4 trillion yuan of soured debt from the banks at face value, thereby protecting the lenders from losses and relieving SOEs of their debt burdens. About 30 percent of those bad loans were swapped into equity as directed by the government.

One big difference with the previous bailouts of 1999 and 2004 is the fact that many of the banks, SOEs and the asset-management companies have since sold their shares, in many cases to international investors, and now have to take shareholder interests into account, says Guangfa’s Mu.

"China has come a long way over the past decade in transforming into a market-oriented economy, so has its banking system," said Mu. "The government shouldn’t backpedal by making banks do things that go against the interest of their shareholders."

Another danger, according to a March 17 report by Moody’s Investors Service, is that removing debt from the books of the SOEs will encourage "unviable" firms to take on yet more loans, further subordinating the claims of lenders which accepted the exchange. "An inevitable collapse" of such firms will only be more expensive for the banks involved, Moody’s said.

Even China’s top banking regulator, CBRC Chairman Shang Fulin, said the swaps won’t be easy to execute. The current law preventing investment in non-bank institutions is intended to protect depositors and some technical details must be addressed before proceeding, he said earlier this month.

While banks are hesitant, China Huarong Asset Management Co., one of the four bad-loan managers that took part in the 1999 bailout and swaps, is actively pitching for a role in any new round of debt-equity conversion. The government should provide 1 trillion yuan to 3 trillion yuan of funding support, with banks, SOEs and asset managers sharing the risks, Lai Xiaomin, chairman of Huarong, said in a proposal to the top legislature earlier this month.

"In the last round of debt-to-equity swap 17 years ago, Chinese government shouldered all the losses," Lai said in Boao last week. "This time, companies and banks all need to share losses."

— With assistance by Jun Luo

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