Photographer: Qilai Shen/Bloomberg

China's Plan to Clear Bad Loans Could Backfire, IMF Staff Warn

  • Converting debt to equity may keep alive `zombie' firms
  • Plan may create conflict of interests for bankers, report says

China’s plan to rid banks of bad loans could backfire, allowing debt-laden “zombie” companies to stay afloat and creating conflicts of interest for bankers, International Monetary Fund staffers warned.

China is drafting rules to make it easier for lenders to convert bad loans into equity stakes in debtor companies, people familiar with the matter said last month, in a move that would help authorities clean up banks’ soured credit, which has climbed to the highest in a decade. Chinese banks may also repackage non-performing loans and sell them as securities. The Chinese government hasn’t released details of the proposal yet.

QuickTake China's Debt Bomb

“While such techniques can play a role in addressing these problems and have been used successfully by other countries, they are not comprehensive solutions by themselves,” the IMF staffers said in a blog post Tuesday that accompanied a short report.

“Unless they are carefully designed and part of a sound overall framework, they could actually worsen the problem,” such as by allowing “zombie” firms to survive, they said.

Banks don’t generally have the expertise to run or restructure businesses, and debt-to-equity conversions could create conflicts of interest, they warned.

Skeptical Voices

The comments add to other voices skeptical about China’s plan to clean up its financial system. China’s top financial regulator has urged banks to move cautiously, while HSBC Holdings Plc’s chief executive officer has said more steps will be needed to resolve the challenge of mounting bad loans.

In a report earlier this month, the IMF estimated that 15.5 percent of commercial banks’ loans to companies -- an amount equivalent to $1.3 trillion, or 12 percent of gross domestic product -- are potentially at risk. Reported “problem bank loans” total $641 billion, or 5.5 percent of banks’ corporate and household loans.

Debt should only be converted into equity for viable firms that have “operational” restructuring plans, the staff report said. The debt should be converted at fair value, and banks should only hold equity for a limited period, said the employees of the Washington-based fund, which was created during World War II to oversee the global monetary system.

If they securitize bad loans, banks should use a diversified pool of loans and maintain some exposure to the assets, thereby keeping “skin in the game,” according to the IMF report. There should also be a legal framework that allows owners of distressed assets to force company restructurings and obtain the best value on the assets, the IMF staffers said.

The report and blog post were written by James Daniel, assistant director of the fund’s Asia and Pacific Department; Jose Garrido, senior consulting counsel; and Marina Moretti, head of the financial-crisis preparedness and management division.

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