China's Debt-For-Equity Swaps Face Implementation Risks, Says Fitch

China's debt-for-equity swaps aim to reduce headline corporate leverage ratios, but are unlikely to change the underlying structural risks in the economy to any great extent, says Fitch Ratings.

The market-oriented framework should help to draw in private investment, if implemented successfully.

However, there is a risk that the scheme may be compromised by implicit government influence and a lack of transparency on the relationships between the parties involved.

Moreover, the authorities have yet to outline plans to deal with the bigger problem of debt residing with 'zombie' companies.

Strategy to reduce corporate debt

The State Council (SC) on 10 October provided guidelines on debt-for-equity swaps as part of a strategy to reduce corporate sector debt, which was equivalent to 169% of GDP in 1Q16.

Debt-for-equity swaps could in principle act as a relatively growth-friendly route to corporate deleveraging.

The scheme has been designed to address issues raised in the Chinese media when Premier Li first proposed debt-for-equity swaps in March - most notably that banks would be compelled to swap bad loans for equity to keep failing 'zombie' companies alive.

Banks will need to transfer loans to "qualified implementing agencies", which will then convert the loans into equity. The conversion price is to be "market-oriented" and negotiated by banks, investors, debtors and the implementing agencies.

The SC's guidelines also state that banks will not be forced into transactions and that firms with no prospects will not be eligible for debt-to-equity swaps.

The idea is that banks, after an initial write-down, will transfer exposure to new investors in the converted equity. Implementing agencies are expected to raise funding from external investors to support the swaps, and the market-driven approach of the scheme could make that easier.

Implementation risks ahead

However, implementation will be key. One risk is that banks could use related parties as implementing agencies. The SC's directive also allows for debt-to-equity to be funded by 'social capital', which is likely to include mutual funds and wealth management products (WMPs).

This raises the possibility of banks retaining their exposure to corporates through complicated ownership and transaction structures that lack transparency. For example, banks' exposure to troubled companies might simply move off-balance sheet if bank-linked WMPs are used to fund swaps.

Another risk is that the process will be prone to government influence. Government has said it will not assume responsibility for any losses involved, and will not intervene in transactions.

However, high levels of moral hazard pervade China's financial sector, and banks are likely to feel pressure to support the government's policy objective of addressing over indebtedness. These problems raise doubts over whether 'zombie' firms will really be kept out of the scheme.

If the scheme is run along the lines proposed, it will only deal with excess leverage in some parts of the economy. Banks will still be left with exposure to the most troubled corporates, which make up a large segment of the corporate debt market and arguably pose the biggest risks to asset quality.

Fitch has long argued that banks will be central to the resolution of China's debt overhang, and that central government funds will be needed to recapitalize the sector if absorption buffers are depleted as losses are realized. Debt-for-equity swaps are unlikely to change that view. 

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