China's debt-for-equity swap (DES) scheme is unlikely to reach a scale at which it addresses corporate sector leverage in a meaningful way, given a lack of investor interest and the capital constraints of banks, says Fitch Ratings.
The structure of DES deals will still leave banks exposed to highly leveraged corporates. Banks' balance-sheet transparency could also be reduced. The state banks that are most active in the scheme are large and relatively strong, but their risk profiles could still be hurt by significant DES participation.
DES could in theory help to reduce corporate-sector debt, which stood at 166% of GDP in 4Q16, without creating a large drag on economic growth. However, Fitch believes the scheme has been held back by a lack of interest from investors outside the banking sector.
The current total contract value of DES deals is around CNY1 trillion, but most of the deals are still unfunded. For example, China Construction Bank has raised funding for only around 10% of its announced DES deals - which account for half of the DES total.
Response to weak investor appetite
New guidance issued last week appears to be a response to this weak investor appetite. It allows entities set up to conduct DES deals to issue bonds or raise interbank funding to support DES deals. Banks' capital constraints will become the main limit on the scale of the scheme, if these entities now start to fund most DES deals in this way.
The guidance does not specify capital requirements for DES entities, but most of them will be subsidiaries of banks and will need to be consolidated in the books of their parents. As such, debt issued by DES subsidiaries - and exposure to DES firms that remains on subsidiaries' books - will affect parent bank capitalization.
That said, it is possible that subsidiaries will use complicated transaction structures to move the exposure off balance sheet and bypass the risk-weight calculation, which could add to banking sector risks.
The DES deals that are completed might only reduce the headline debt of corporates temporarily. Banks often require the right to sell their equity back in three to five years - and apply interest - if the company fails to meet specific performance targets, making the equity investment "debt" in essence.
DES is unlikely to be an effective way to address the structural problems of debt-laden companies, particularly if deals are not accompanied by fundamental reforms to companies' business models and operations.
Moreover, the lack of disclosure and absence of a clear definition of 'zombie' firms makes it difficult to assess whether regulations are effective in excluding unviable firms from DES deals. This may leave room for unviable companies to use swaps as a way to put off bankruptcy and support unprofitable operations.
The latest DES guidance continues to prohibit zombie firms, but it now makes clear that top-ranked, highly leveraged companies in over-capacity industries, such as coal and steel, are allowed to participate. In reality, these sectors had already been the most active in DES, with over half of the deals already arranged involving companies in the coal and steel sectors.
That share could now rise even further as result of the new guidelines, notes Fitch.