MNI ANALYSIS: China Debt Swap Plan Lagging As Enthusiasm Wanes

--Indebted Companies Are Being Asked to Repurchase Swapped Equity at Fixed

Interest

--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

funded."  

     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

debts. 

     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

investors." 

     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.

--MNI Beijing Bureau; +86 (10) 8532 5998; email: marissa.wang@marketnews.com

--MNI Beijing Bureau; +86 (10) 8532-5998; email: vince.morkri@marketnews.com

--MNI BEIJING Bureau; +1 202-371-2121; email: john.carter@mni-news.com

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