China debt-for-equity swaps turn out to be futile

The original lenders to now-troubled firms aren’t encouraged to swap their own credit for shares

by BLOOMBERG

Hong KongA key Chinese initiative to rein in the world’s largest corporate-debt load has been a programme swapping some loans into equity stakes. As the initiative gets going, however, it’s becoming clear the debt isn’t really going away.

In a late-summer notice, central government officials said new bonds should be used to finance the swaps, effectively moving the debt off the balance sheets of the original lenders onto those buying the new debt.

The first such deal came last month, according to China Lianhe Credit Rating Co, a domestic rating firm. Shaanxi Coal and Chemical Industry Group Co, a troubled old-line industrial company, was targeted for a debt-for-equity swap. Then the Shaanxi provincial government in northwest China set up an asset-management company to raise new debt to pay off the existing lending that was designated to be swapped for an equity stake.

One criticism of the debt-for-equity initiative is that it keeps afloat struggling enterprises, leaving excess capacity intact and pulling down productivity. The Shaanxi example shows a further weakness: While the company won’t need to service debt any more, the new asset-management unit will — without any new source of revenue having been generated.

“If the funding comes from debt, it’s really not solving the issue here because the capital is not permanent capital,” said Christopher Lee, MD of corporate ratings at S&P Global Ratings in Hong Kong. “In fact, you are adding more debt just to refinance the debt that was going to be swapped.”

Because of potential conflict of-interest concerns, the original lenders to now-troubled companies aren’t encouraged to swap their own credit for shares. Instead, new entities are raising financing that allows the original creditors to offload those assets.

In last month’s operation, Shaanxi Financial Asset Management Co sold 500 million yuan (RM320 million) in six-year bonds in a private placement, China Lianhe Credit Rating said in a Sept 26 report. The asset manager has already signed 40 billion yuan of debt-swap agreements with Shaanxi Coal and Chemical, the report said.

The total value of lending designated to be swapped into equity in China has topped one trillion yuan, involving more than 70 companies, according to an official statement in August. Though plenty of deals have been announced, there are major gaps in funding, with institutional investors remaining cautious about the programme and banks also reluctant to dive in.

For example, China Construction Bank Co had signed 544.2 billion yuan of swap deals with 41 companies by the end of July, but less than 10% of that had been funded, according to the bank.

While it’s still a work in progress, the advantage of the programme is that the financial risks stemming from these mainly state-owned enterprises (SOEs) will be diversified, through the participation of private companies and financial institutions along with local authorities, according to advocates including China Lianhe Credit Rating.

A bigger question is whether the initiative will end up reducing debt, however. That ultimately depends on the valuation of the equity stakes taken by the financing units involved. If companies turn around and the shares climb, then the units can sell and retire the new debt. If not, then the private sector is saddled with soured SOE obligations. — Bloomberg