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China's debt-to-equity swap initiative may do little to deleverage economy

China's"market-oriented" debt-to-equity swap initiative is unlikely to bringdown the country's massive corporate loans, as banks may find corporates withgood underlying prospects unwilling to convert their loans into equity.

Themeasure, which aimsto deleverage the corporate sector, is aimed at relatively healthy companieswith a sound credit track record and bright growth prospects but faceshort-term funding difficulties. "Zombie companies" and deliberatedefaulters fall out of the scope of the initiative, according to an Oct. 10State Council circular. A quota and time frame for the program was notspecified.

Themove comes as China's corporate debt is estimated to be 166% of 2015 GDP, accordingto the Bank for International Settlements. S&P Global Ratings estimates thefigure to rise to 180% of 2016 GDP in a downside scenario. Additionally,the nonperforming loanratio of the financial system was 1.81% as of the second quarter, the highestsince the global financial crisis in 2009, in an environment where the countryis aggressively boosting lending to drive growth.

China'sState Council first floated the idea of deploying the debt-to-equity swap as a tool to lowercorporate leverage in March. The debt-to-equity swap is among multipleinitiatives put forward by the State Council to reduce corporate debt in thecountry. Other such moves include encouraging M&A, bankruptcies anddebt securitization.

Underthe initiative, lenders and borrowers will have to work with implementingentities to convert loans into equity shares. They also have to negotiate theterms and pricing for transferring the debt obligations on a market-drivenbasis, the circular said.

"Itwill be difficult for the different parties to reach consensus," said ChenShujin, a banking analyst at DBS Vickers (Hong Kong).

Healthiercompanies will be reluctant to swap their loans for shares, as this woulddilute existing shares and reduce the companies' return on equity, she said.However, banks and implementing entities would be inclined to do so in order tobenefit from the potential upside and ultimate exit from the debt, Chen said.

Companieswith better growth outlooks also have other options to explore in order torefinance and restructure their debt, said Andy Leung, a banking analyst at KGISecurities.

Onthe 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 torecover part of the debt after assets are liquidated, Chen said.

Shareswould be worthless if the companies are in bad shape and cannot pay outdividends, Leung added. Banksmay also record asset impairment losses if the debt price is too low whenconverting the corporate loans, he said.

Thethird-party entities that will handle the debt conversion, which may be banks'own subsidiaries or other asset management companies, are encouraged to sellthe shares to investors, such as entrusted funds, through bond issuances orother means, according to the circular.

Introducingthe implementing entity into the swap process means banks will not have to bearcorporate management responsibility after converting corporate debt intoequity, Leung said. This would also relieve lenders' concerns about a hit totheir capital ratios, which would occur if banks were to hold companies' sharesdirectly, as their risk-weighted assets would increase and eat into commonequity capital buffers.

Ultimately,the debt-to-equity swap initiative will do little to help deleverage theeconomy, as corporate loans are growing at a much faster rate than loans areconverted into shares, Chen said. S&P Global Ratings projects that thecorporate credit-to-GDP ratio may rise above 200% in a downside scenario asearly as 2018.

"Leverageis not likely to go down. China can only control its rise now," Chen said.

S&P Global Ratingsand S&P Global Market Intelligence are owned by S&P Global Inc.