China's "market-oriented" debt-to-equity swap initiative is unlikely to bring down the country's massive corporate loans, as banks may find corporates with good underlying prospects unwilling to convert their loans into equity.
The measure, which aims to deleverage the corporate sector, is aimed at relatively healthy companies with a sound credit track record and bright growth prospects but face short-term funding difficulties. "Zombie companies" and deliberate defaulters fall out of the scope of the initiative, according to an Oct. 10 State Council circular. A quota and time frame for the program was not specified.
The move comes as China's corporate debt is estimated to be 166% of 2015 GDP, according to the Bank for International Settlements. S&P Global Ratings estimates the figure to rise to 180% of 2016 GDP in a downside scenario. Additionally, the nonperforming loan ratio of the financial system was 1.81% as of the second quarter, the highest since the global financial crisis in 2009, in an environment where the country is aggressively boosting lending to drive growth.
China's State Council first floated the idea of deploying the debt-to-equity swap as a tool to lower corporate leverage in March. The debt-to-equity swap is among multiple initiatives put forward by the State Council to reduce corporate debt in the country. Other such moves include encouraging M&A, bankruptcies and debt securitisation.
Under the initiative, lenders and borrowers will have to work with implementing entities to convert loans into equity shares. They also have to negotiate the terms and pricing for transferring the debt obligations on a market-driven basis, the circular said.
"It will be difficult for the different parties to reach consensus," said Chen Shujin, a banking analyst at DBS Vickers (Hong Kong).
Healthier companies will be reluctant to swap their loans for shares, as this would dilute existing shares and reduce the companies' return on equity, she said. However, banks and implementing entities would be inclined to do so in order to benefit from the potential upside and ultimate exit from the debt, Chen said.
Companies with better growth outlooks also have other options to explore in order to refinance and restructure their debt, said Andy Leung, a banking analyst at KGI Securities.
On the flip side, if banks are uncertain about the financial health of a company, they may prefer to let the borrower default and go bankrupt, in order to recover part of the debt after assets are liquidated, Chen said.
Shares would be worthless if the companies are in bad shape and cannot pay out dividends, Leung added. Banks may also record asset impairment losses if the debt price is too low when converting the corporate loans, he said.
The third-party entities that will handle the debt conversion, which may be banks' own subsidiaries or other asset management companies, are encouraged to sell the shares to investors, such as entrusted funds, through bond issuances or other means, according to the circular.
Introducing the implementing entity into the swap process means banks will not have to bear corporate management responsibility after converting corporate debt into equity, Leung said. This would also relieve lenders' concerns about a hit to their capital ratios, which would occur if banks were to hold companies' shares directly, as their risk-weighted assets would increase and eat into common equity capital buffers.
Ultimately, the debt-to-equity swap initiative will do little to help deleverage the economy, as corporate loans are growing at a much faster rate than loans are converted into shares, Chen said. S&P Global Ratings projects that the corporate credit-to-GDP ratio may rise above 200% in a downside scenario as early as 2018.
"Leverage is not likely to go down. China can only control its rise now," Chen said.
The article is authored by Jolie Ho at S&P Global Market Intelligence.