Finance

Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

The Chinese discovered how to make gunpowder more than 1,000 years ago, but for a long time they loved it more for the fireworks it allowed. It took foreign devils from the West to see the value of using gunpowder in weapons for it to become the game changer that helped small countries like Portugal, Spain and England dominate half the globe.

Once again, the Chinese seem to be focusing on the show rather than the killer ingredient. This time, it's debt-for-equity swaps, imported from the West. While there's been a slew of explosive headlines about China's great deleveraging, the few examples that have surfaced so far are underwhelming.

China Construction Bank has spent time talking up its some 50 debt-for-equity swap plans, and indeed is at the fore of the trend, conducting transactions with companies including Yunnan Tin and Wuhan Iron & Steel after policy makers released guidelines on how to reduce corporate leverage. 

An America of Debt
Chinese companies owe more than $18 trillion, almost as much as the entire U.S. gross domestic product
Source: Bank for International Settlements

A closer look at what's been going on, however, suggests something of a smokescreen.

Take Yunnan Tin, which analysts last year expected to default. A unit of Construction Bank has set up a 10 billion yuan ($1.5 billion) fund that will help the world's largest tin smelter repay some of its more expensive debt, most of which is owed to other lenders. In return, the fund gets a stake in some of the company's operating subsidiaries, the caveat being that Yunnan Tin must buy back those interests within a few years.

Wuhan Iron & Steel's restructuring involves a similar workout. Details are scant but a 21st Century Business Herald report quoted a Construction Bank executive as saying the lender had a return target that if not achieved would require Wuhan to make up the shortfall.

Both cases hardly look like a traditional Western restructuring, where debt is actually converted to equity, diluting shareholders and imposing losses on creditors. It isn't like Construction Bank is taking an immediate haircut in either scenario. On the contrary, the plans create new loans that are simply backed by equity in key units, meaning indebtedness may actually increase.

Making matters worse, Chinese banks say they're reducing their exposure by getting wealth-management products to invest in the swaps. Many of these products are created by the lenders themselves and form part of China's shadow banking industry. Therefore, while the liability may be leaving the balance sheet at no cost, the bank ultimately remains on the hook. It also means yield-hungry individuals who buy the investments are vulnerable as well.

Much like the mix of charcoal, sulfur and saltpeter discovered a millennium ago, this is shaping up to be one dangerous cocktail.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Christopher Langner in Singapore at clangner@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net