Shuli Ren is a Bloomberg Gadfly columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.

Just when China's bad-debt situation was starting to look better, Beijing opens a fresh Pandora's box.

Earlier this month, the banking regulator released a consultation paper on allowing commercial lenders to set up asset management companies to carry out debt-to-equity swaps. The nation's five biggest banks have already been operating pilot programs since October.

The plan is a roundabout -- and dangerous -- way to reduce corporate debt. China doesn't allow banks to convert loans into equity directly, unless borrowers have defaulted. So the new asset management companies are being set up as intermediaries to hold the shares instead.

But banks will clearly be responsible for all the credit risks these middle-men take on. Lenders must own at least 50 percent of the companies' capital, according to the regulator, making them the majority shareholders. In fact, the big five own 100 percent of their asset managers.

Sorry State
State-owned enterprises account for 97 percent of swaps, including the biggest five
Source: HSBC Holdings Plc

More than 85 percent of the 1 trillion yuan ($150 billion) of debt-swap contracts signed so far are with local state-owned enterprises, HSBC Holdings Plc estimates. Over half of deals are in the troubled coal and steel industry, according to Fitch Ratings.

Who Gets the Bailout?
Coal and steel companies account for more than half of debt-for-equity swaps so far
Source: Fitch Ratings

Will the new asset managers have enough capital to deal with state-owned enterprises on the verge of bankruptcy? Banks that restructure defaulted loans into equity are required to hold much higher levels of capital: 400 percent of the value of the stake for the first two years after conversion, and 1,250 percent thereafter.

Beijing has set the requirement at 200 percent for the asset managers, to encourage lenders to establish the companies. In return, they are required to hold their shares for at least five years, giving those troubled coal and steel firms some breathing room. But what if they still can't recover?

So far, only about 10 percent of the announced 1 trillion yuan of debt-swap deals has been funded, because private-sector investors aren't interested. These swaps can't be good deals, given they are likely to be done at the face value of the loans.

Bank asset management companies are nothing like the traditional breed such as China Cinda Asset Management Co., which specialize in buying non-performing loans. The new managers will take on only healthy loans, or at worst those in the "special mention" category, because in theory, state-owned companies can't default.

Beijing wants to do this, whether there is private investor interest or not. The asset managers will have a wide range of financing options, from bond issues to privately placed loans to even tapping interbank liquidity, according to the consultation paper. However, the only way for these new entities, which have no credit profile, to get any form of financing is through the implicit bank guarantee that investors will perceive. 

We are seeing a new form of shadow banking sprouting.

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

To contact the author of this story:
Shuli Ren in Hong Kong at

To contact the editor responsible for this story:
Matthew Brooker at