China's government has looked at debt-for-equity swaps as one way to cut debt levels at the country's industrial giants, but the arrangements struck since the policy's rollout suggest that deleveraging may only take place in name on companies' balance sheets.
Debt-to-equity swaps as a debt resolution tool were first floated by the government in March 2016, amid corporate debt levels potentially reaching as high as 180% of 2016 GDP in a downside scenario, as estimated by S&P Global Ratings. Other such moves put forward by Chinese authorities have included encouraging M&A, bankruptcies and debt securitization.
Later in October 2016, the State Council decreed that such swaps have to be carried out by subsidiaries set up by banks to specialize in the conversions, and that the state-owned enterprises involved have to be relatively healthy.
Since then, the country's four largest banks, Industrial & Commercial Bank of China Ltd., Bank of China Ltd., China Construction Bank Corp. and Agricultural Bank of China Ltd., have signed debt-to-equity swap agreements totaling 300 billion yuan with 23 enterprises, National Development and Reform Commission Chair Xu Shaoshi said at a January press conference.
Based on available details of already arranged swaps, the moves appear to only remove debt and lower the leverage levels of these corporates on paper, Caixin reported Jan. 17.
Under the conversion mechanism, a state-owned enterprise gets the bulk of the financing for swapping their debt into equities from a wealth management fund set up by a bank subsidiary. The company itself is likely to contribute to part of the financing by forming a partnership with the wealth management fund.
One major consideration for banks is how to eventually exit from holding stakes in state-owned enterprises and generate returns for investors in the wealth management products bankrolling these swaps.
To do so, banks have added on terms to provide fixed returns through repurchase agreements, as seen from existing swap arrangements. Hence, these equity stakes held by banks have been called "fake equities," as they take on features similar to those of fixed-income products, instead of behaving like equity.
Through a partnership structure with the wealth management fund, state-owned enterprises can boost their equities exposures and in turn lower the gearing ratio from an accounting perspective, Chen Shujin, an analyst at Huatai Securities, told S&P Global Market Intelligence.
"These are 'fake equities.' [Converting debt to equity] can appear to lower the leverage ratio, but in fact it doesn't," said Liao Qiang, senior director of financial institutions at S&P Global Ratings.
On the books these are just regular equity stakes held by shareholders, even if the companies may promise to repurchase the equities in the future and pay fixed interest to those providing financing, Liao added.
Corporates should not be able to pay fixed interest to equity holders under such a scenario, because if they could do so, they would not need to swap their debt for equity at all, said Wei Hou, a Hong Kong-based senior analyst at Sanford C. Bernstein.
Meanwhile, Shang Fulin, chairman of the China Banking Regulatory Commission, told a meeting of banking regulators that authorities will soon release specific rules on the scope and control mechanisms for debt-to-equity swaps, Caixin reported.
"We need to fully implement develeraging; it's not simply a matter of balance sheets looking good, but to actually realize change," Shang was cited as saying, without commenting specifically on the issue of debt-to-equity swaps.
Huatai Securities' Chen, however, thinks Chinese authorities may not take serious action against the introduction of equities carrying debt-like features, as this helps draw potential investors in.
"Shang's words show that regulators do not encourage this, but I think they won't take serious action either," Chen said.
Ultimately, exchanging debt at state-owned enterprises for equity shares may only be a short-term solution to lower leverage temporarily, Hou said.
In the long run, corporate debt levels can only be lowered by improving the profitability of the business.
"Some corporates have climbing loans because of over-expansion in the past or poor profitability ... In that case they have to work more on operational improvement, otherwise they will still have problems running the business and have to borrow more loans after this round of debt-to-equity swaps," Hou said.
S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.
As of Feb. 8, US$1 was equivalent to 6.88 Chinese yuan.