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--Indebted Companies Are Being Asked to Repurchase Swapped Equity at Fixed
--Banks Finding it Hard to Get Funding for the Debt Swap Schemes
BEIJING (MNI) - So far, China's corporate and local government debt swap
push has had only a limited impact on reducing corporate debt burdens. And the
outlook is suspect.
The plan faces several obstacles to success given the low rate at which
currently contracted swap agreements are being carried out and because the level
of enthusiasm shown for the program by banks and companies has waned.
The debt-to-equity swap market has seen significant action since its
inception last October, with the four main state-owned asset management
companies (AMCs), as well as commercial banks, other AMCs run by state-owned
banks, and AMCs run by local governments all participating. Among these,
however, commercial banks are the main players in the swaps.
The swaps are seen by the government as an effective tool in dealing with
the country's growing pile of non-performing loans, at once helping banks
offload their NPLs to AMCs while at the same time reducing companies' debt
pressures, further improving the companies' operating structures, and allowing
banks or AMCs to become shareholders in the companies.
The total contracted value of swap agreements involving 77 companies --
mostly state-owned enterprises (SOEs) -- rose to over CNY 1.3 trillion as of
Sept. 22, according to the National Development and Reform Commission (NDRC).
However, only about 10% of these agreements have actually been carried out,
Liang Qiang, assistant CEO of Cinda Asset Management Corp., said during a press
conference in Beijing last week. Cinda is one of the big four state-owned AMCs
that have been given the task of handling banks' toxic loan assets, although
they are focused on money owed to state-owned banks.
The country conducted the first round of swaps in 1999-2000, when it set up
the four state-owned AMCs -- the other three are China Huarong Asset Management,
China Great Wall Asset Management, and China Orient Asset Management -- to clean
up about CNY1.4 trillion worth of bad loans from state-owned banks. The exercise
successfully ring-fenced a potentially catastrophic financial risk, but also
created a moral hazard, as it helped bail out many "zombie" SOEs that otherwise
would have failed and deferred contagion risks into the long term.
The second round of swaps, which started in October 2016, is being carried
out under the broad theme of "deleveraging," and the State Council, the
country's cabinet, argues the scheme is more market-driven than
government-determined, with only companies facing "temporary difficulties"
allowed to participate in the swaps and the zombie SOEs no longer allowed.
"The aim of this round is to lower the liability-to-asset ratio of
companies suffering from highly leveraged debts, particularly leading
state-owned enterprises in targeted sectors, including coal, steel and
non-ferrous metals," Liao Zhiming, banking analyst with Tianfeng Securities,
told MNI. "So the debt the swaps target is not necessarily the non-performing
loans of banks this time. Special-mention loans [those for which borrowers are
experiencing some difficulties in repaying] and even some good loans have been
included in the swaps."
In practice, the debt-swap scheme faces something of a dilemma, as
fund-raising has become a headache for banks due to low returns, and because it
is very difficult for banks to withdraw from the debt-to-equity deals once they
are agreed, owing to the opacity of relevant regulations.
A source who works at one of China's "Big Five" state-owned banks told MNI:
"Some banks invest capital from their wealth management products" to buy equity
stakes in the failing companies, thereby raising banks' funding costs.
"The swap process also sucks up banks' liquidity" and banks usually cannot
expect to see positive capital returns from such deals from five or even 10
years, the source said. "Given that the durations of the WMPs are quite short,
how to guarantee income for WMP investors is also a major issue."
Wealth management products are a profitable option for investors in China.
They offer high yields and are de-facto guaranteed, as banks that sell WMPs
stand behind them even when they sour. According to PY Standard, a Chinese data
provider, the average yield of banks' WMPs in October was 4.58%, compared with
the 1.5% benchmark interest rate for a one-year deposit.
What is more, the swap program was originally intended as a way for banks
to target specific heavily indebted companies for restructuring in hopes of
turning the companies into profit-making entities. But the capacity for banks to
carry out governance reforms of the companies in which they now own stakes has
been a major source of concern.
"The easy way [for banks to make money during the process of swaps] is
through fixed income, so usually banks make 'drawer agreements' with companies,
asking them to repurchase the equity [the have swapped with banks] at a fixed
interest rate within a certain required time rather than accept dividends as
shareholders," the source said, "so it is substantially still a debt that
companies must repay."
According to publicly available documents on debt-to-equity swaps struck by
banks, the deals mostly require companies to pay around 5% annual fixed income
to the banks, and many of the agreements specify that companies need to buy back
the equity stakes within five years, as banks are worried that the mechanism
allowing banks to get out of the transaction in a profitable and smooth way is
still immature and companies' capacity to make a profit within five years is
also in doubt.
This is an obvious feature of so-called "nominal equity, actual debt"
transactions, a controversial operation within the debt-to-equity swap scheme.
The transaction actually postpones the debt payments, and in the long run it
could increase the debt default risk of the indebted companies if they do not
carry out needed structural reforms.
Sun Zhigang, the chairman of Cinda Securities, said during a Beijing
financial summit in June that banks usually do not want to hold corporate equity
over the long term because doing so cuts into their liquidity, and also because
banks' experience in corporate management is quite limited. So the "nominal
equity, actual debt" transaction is preferred.
"Whether banks should play a role as shareholders in the process of this
round of swaps poses a big challenge," Sun said.
The source at one of the Big Five banks said "the main reason that more of
the contracted debt-to-equity swaps haven't been carried out is because
repurchase interest rates set in the swap deals between banks and companies are
usually 5% to 6%, which is too low considering that yields in the bond market
and money market are rising, so it is even harder to get debt-swap proceeds
Some companies, particularly those in the steel, coal and non-ferrous
metals sectors, have little need to swap their debts at the moment, as they have
greatly benefited from China's industrial capacity reduction campaign, with many
seeing their profit surge, meaning they are more than capable of repaying any
Moreover, moral hazards related to the swap program are also a concern. For
example, the standard by which the government selects companies to participate
in the swaps is still not transparent, although government authorities have
promised they would not let failing companies initiate debt swaps as a way of
getting a government bailout.
Li Xuezhi, an analyst with Bank of Communications, told MNI: "Companies are
seeking to reduce debt at the lowest cost, so they are likely to pick the
highest-risk assets and dress them up to meet the requirements of [the
debt-to-equity swap program], which would jeopardize the interests of
As a result, he warned, regulations governing the debt-to-equity swap
program "should be further strengthened."
As financial stability has become the overriding concern of policy-makers,
banks shoulder responsibility in reining in debts while not impacting the
country's overall economic growth. But some argue that the buck should not stop
with banks alone and that private investors need to brought into the process.
"Capable social capital [funds from private investors] should play a main
role in the process of the scheme, not banks, which should be more
market-oriented," Liao Zhiming, the Tianfeng Securities analyst, said.
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