China finds a new way to hide its debt bubble

The problem with the debt-to-equity plan is three-fold. Firstly, converting debt at insolvent state-owned enterprises (“SOEs”) into equity, and having commercial banks hold that illiquid equity on their balance sheets, will weaken the stability of the banks and force them to hold more reserves against the riskier (or potentially worthless) equity. In an attempt to mitigate the concerns of many bank executives and market analysts, the swap guidelines permit only healthy companies facing temporary obstacles to qualify for the swaps, and do not force banks into accepting swap arrangements. While the intention is clearly to prevent zombie companies from accessing these swaps, it does nothing to encourage efficient capital allocation, nor address the moral hazards posed – that inefficient SOEs could use the swaps to avoid paying debts and delay the inevitable slide into insolvency, while simultaneously weakening the financial institutions.

Secondly, the plan is unlikely to be truly “market-oriented” despite the stated intentions of the regulators. Consider this: if a healthy company is facing temporary liquidity headwinds, why would it want to dilute its shareholders by giving equity to a bank? Conversely, if a company is facing structural issues and is actually in need of a debt-to-equity swap to remain solvent, why would commercial banks want a piece of the equity? Case in point: the first debt-to-equity swap arranged under the new guidelines was an RMB 10 billion deal between China Construction Bank (China’s second largest lender) and an SOE, Yunnan Tin Group, struck at face value. Some market participants questioned why the deal was not struck at a discount, given that is how the market would typically price distressed debt-to-equity swaps. Furthermore, Yunnan Tin recorded RMB 6 billion of losses in the last three years, and its book value shrank by a third – this is hardly the picture of a “healthy” company facing temporary headwinds that a market-oriented bank would want equity exposure to.

Finally, these swaps simply spread the risk across the financial system. Taking the Yunnan Tin example again, China Construction Bank plans to raise the majority of the capital for the equity injection from other financial institutions, including insurance companies, pension funds and wealth management products (WMPs). Instead of being concentrated on banks’ balance sheets, exposure to uncreditworthy or insolvent companies is now spread across the financial system. Ironically, because of the implicit guarantees that Chinese banks provide to their WMPs with respect to returns, it is likely that banks are simply moving their existing nonperforming loan exposures off-balance sheet.

In summary, it is safe to say that these new debt-to-equity swaps can be added to the growing list of systemic risks to the Chinese financial system, that already include unsustainable credit growth, ongoing credit-driven malinvestment, and the rise of wealth management products.

Written by Daniel Wu, Research Analyst. Contributed by Montgomery Global Investment Management:  (VIEW LINK)