The debt-equity swap scheme, a key strategy that Beijing uses to deal with bad loans and restructure the corporate sector, has shown implementation progress, but there is also evidence that it is not working properly, with the number of zombie companies and their losses still growing.
With the economy recovering from the COVID-19 shock, Beijing is expected to return to its debt-reduction efforts after the double-whammy of a trade war with the US and the pandemic.
That should increase the number of equity deals under the swap scheme, but it is unlikely to function properly due to
To tackle the problem with non-performing loans (NPLs), Beijing asked the Big Five state-owned banks to set up asset management companies (AMCs) in 2016 to undertake debt-equity swaps. This scheme differs from the previous one in that zombie firms (defined as companies that earn just enough money to continue operating and service debt, but are unable to pay off the principal) are not allowed to participate. Only indebted companies that still have growth potential in strategic emerging industries and national defence and related sectors are eligible.
The good news is that the programme has expanded in scale over time, with 40% of the total signed-swap value executed by April 2019. This is up from just 9% in early 2017. The number of private firms participating in the swaps rose from 1.2% in September 2017 to 6.5% in April 2019. Both numbers shows China’s implementation of the debt-equity swap programme has improved.
However, the evidence also shows the debt-equity programme had not been functioning properly. China’s total non-financial sector debt-to-GDP ratio started rising again after staying flat between 2017 and 2018 (see exhibit 1).
The recent rise in the ratio came as GDP contracted and Beijing shelved the deleveraging policy and moved to protect growth and jobs from the trade war and Covid-19 shocks. Meanwhile, zombie firms and their total loss amount have continued to grow. Within the state sector, the share of loss-making state-owned enterprises (SOEs) has been rising since 2016, which highlights the poor functioning of the programme in restructuring China’s zombie firm problem.
With China’s supply-side reform focusing on industrial consolidation to lift the operating efficiency of the large firms and SOEs, the debt-equity swaps will not be able to force the exit of large zombie firms. Many of these firms continue to live on borrowing and debt roll-overs under regulatory forbearance.
In principle, a debt-equity swap is a market selection process to pick ‘losers’ for restructuring. The first thing the new equity holders should do is to restructure the company and replace management. But in China’s debt-equity swap scheme, the new equity owners are the state bank-owned AMCs. Arguably, the swap just changes the label of the state-owner from bank to AMC without serious restructuring incentives. The swap also increases the equity share of state-ownership in the companies, hurting corporate governance.
Furthermore, a good and viable company would not want to surrender its equity to state-owned AMCs. So the programme’s design creates moral hazard with bad companies defaulting on purpose to initiate debt-equity swaps as a way to get bailouts.
This, in turn, leads to an adverse selection problem by attracting mainly bad companies to the scheme; many state firms and banks still see the debt-equity swaps as just another way to save the SOEs and socialise bank losses. As long as this bailout mind-set overwhelms market discipline, it is an obstacle to a genuine clean-up of the zombie firms and NPLs.
In addition, a regulatory flaw is eroding banks’ incentives to do the debt-equity swap properly and directly. It prompts them to set up AMCs to do the job. Since bad debt attracts a loan-loss coverage ratio of 150%, banks can free up liquidity on their balance sheets for more loan growth by offloading NPLs to the AMCs.
But if a bank holds an equity stake in a non-financial company, it has to pay a risk capital charge of 400% if the equity is a result of a policy deal with State Council approval or a court order to swap debt for equity of the borrower. For any other cases, the risk charge goes up to 1,250%!
So converting debt into equity is hugely punitive for banks. AMCs, however, are subject to a risk capital charge of 200% for holding an equity stake of a company. So creating AMCs to do the debt-equity swap will ease the banks’ capital burden significantly.
Finally, the pricing mechanism of China’s debt-equity swaps is broken. In a market-oriented solution, the buyers always value the equity interest at a deep discount to the face value of the NPLs, which become equity after the swap. But Chinese AMCs buy the NPLs at face value and then swap them for equity at the same value in the SOEs. This has been the practice of the AMCs since 1999. So there is no market-clearing.
The emphasis on preserving the SOEs for the sake of maintaining stability risks aggravating this incentive problem and creating more moral hazard. This good-bank bad-bank scheme will help re-liquefy bank balance sheets and stabilise the system in the short term as bad loans are being shovelled off bank balance sheets into AMCs at face value. However, the moral hazard and incentive problems remain.
The failure of the debt-equity swap programme is a wake-up call to pursue genuine structural reforms. With the economy recovering from the pandemic, it pays for Beijing to shift the focus from mere growth protection to serious economic and financial reforms and allow market forces to work to reduce structural distortions and improve resources allocation.
However, in September, the central government called for an increase in the Communist Party’s influence in the private sector. The party should guide private firms to improve their corporate governance structure. This underscores our long-held argument that the market is only a strategic tool that Beijing uses to implement economic reforms under the Party’s ‘visible hand’ guidance.
From a global perspective, efforts to formalise party control of the private sector represent a potential disruption to the international trade framework. Such a move could force more western market economies to consider how much state intervention they are willing to tolerate.
Arguably, the fact that China has released this policy at a time of heightened Sino-US tensions, especially over technology, speaks volumes about its confidence in its role and influence on the global stage.
 The Big Five are Industrial and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), China Construction Bank (CCB), Bank of China (BoC) and Bank of Communications (BoCom).
 Such companies, given that they just scrape by meeting overheads (wages, rent, interest payments on debt, for example), have no excess capital to invest to spur growth.
 For more discussion on China’s reform incentive problems, see “China’s Impossible Trinity: The Structural Challenges to the Chinese Dream”, chapter 4, Chi Lo, Palgrave Macmillan 2015.
 See “The CCP’s New Directives for United Front Work in Private Enterprises”, John Dotson, The Jamestown Foundation, September 28, 2020 https://jamestown.org/program/the-ccps-new-directives-for-united-front-work-in-private-enterprises/
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