Jan 24, 2017 04:29 PM

Questions Surface Over Certain Debt-to-Equity Swaps

(Beijing) — China’s debt-to-equity swap program appears to be making headway, but there are concerns that some arrangements seem more like loans piled on loans and offer debt relief that is more cosmetic than real.

Since November, China’s big four, state-owned banks have each created special subsidiaries to implement the national strategy, which is designed to reduce the debt burden on companies by replacing high-cost bank loans with capital from more-patient equity investors. When the debt involved is not being paid, a swap can also relieve a bank of a bad loan.

At a recent meeting, Shang Fulin, chairman of the China Banking Regulatory Commission, said banks must ensure that the sales of debt in the swap program are real, in the sense that the bank is no longer exposed to the risk.

Two decades ago, China launched a debt-relief program when four asset management companies took a combined 1.4 trillion yuan ($204 billion) of sour loans, at face value, from the books of the big state-owned banks. Some of those loans were turned into equity in the borrowing companies.

But this time, Beijing has repeatedly said that the swap program is different because it will be “market-driven.”

In less than three months, the big four banks together have reached agreements with 27 enterprises to resolve debts worth more than 330 billion yuan, according to public announcements.

The most active bank, China Construction Bank (CCB), has agreed with at least 11 state-owned enterprises to have 235 billion yuan of debts — owed to itself and other lenders — repaid through the swap program, using the bank’s own capital and funds from other sources, which it did not specify.

Theoretically, investors providing the funds to pay off the debts would become the firms’ shareholders — as the swap policy’s name suggests.

The banks have not published details of their swap agreements, so it is unclear how those investments were made and whether all those investors were becoming shareholders.

According to material Caixin has reviewed, the big four banks, including CCB, planned to implement the swap program by creating an investment fund, using capital from their own wealth management products, with the debtor company being a partner in the fund.

In the simplest case, the jointly owned fund buys the equity of the enterprise’s subsidiaries — a straightforward debt-for-equity swap.

Under another proposed scenario, however, the fund doesn’t actually make an equity investment. Instead, it provides a new loan to the debtor company. A similar method presented by the material shows the fund pursuing an arrangement known as “Ming Gu Shi Zhai” in Chinese, which literally translates as “equity in name, debt in essence.” The investment functions like a loan in the sense that the company selling its equity shares must buy them back in the future at a higher price.

The debtor enterprise benefits not only because the new funding, if it is provided in the form of loan, carries lower interest rates. The way the arrangements are made, it can also consolidate the fund into its own assets. This would, in turn, reduce its leverage ratio, making the swap project look good on the surface.

“This method was tried in 1998, but it did not work very well,” said an official from the central bank. For the bank that made the loan and had it replaced, the risk remains real through its exposure to the investment fund, even though it may not look as serious on its balance sheet, he said.

“For a debt-to-equity swap to be ’market-driven’, it needs to be spontaneously formed,” the central bank official said, meaning they would have done the deal on their own without government pressure. “Whether what has happened was spontaneous, everyone knows but they keep it to themselves.”

To be fair, the bank did not invent these practices. Passing off loans as equity investment is common among Chinese financial institutions including other banks. A trust company has been burned recently trying to recover a disputed investment, bringing into the spotlight legal ambiguities surrounding the issue.

So far, the government has allowed the practices to continue, but recent documents about the swap program no longer contained references to “Ming Gu Shi Zhai,” a bank executive with access to those documents said.

The omission may have been what caused a rumor on Jan. 11 that said the big four banks had suspended their swap program because the National Development and Reform Commission (NDRC), China’s top economic planner, had banned “Ming Gu Shi Zhai.” The NDRC made an announcement the same day, refuting the claim as “fabricated.”

Meanwhile, the government seems worried that banks may be simply kicking the debt can down the road by shifting and hiding risk tied to risky and nonperforming loans.

It is important that everyone understands that the swap program is “not about making their books look good,” said Shang, the chief banking regulator. “It’s about really serving the purpose. In practice, some (behavior) was apparently conducted to circumvent regulations. This may allow temporary relief, but it will lead to risk, and the risk will keep growing,” Shang said. He did not elaborate.

During a routine news briefing, Chen Caihong, secretary of the CCB’s board of directors, said the debt-to-equity swap program is, above everything else, about “banks serving the national strategy and reducing corporate leverage ratios. Under this precondition, the commercial banks’ own demand for sustainable development should be fully met,” he said.

When asked about whether the bank’s recent swap investment was actually a loan, Sun Jianzheng, an investment manager at the bank, said, “Equity shares and loans are hard to tell apart and define.”

“The difference between them lies in returns,” he said. “There is no agreed-upon fixed return on the investment, so it’s not debt.”

Sun said the bank chose those enterprises — many of which benefited from the debt-relief program 18 years ago — because they have “broad development prospects.”

Once its leverage ratio is reduced, the debtor company will be able to start anew, get new funding and have a bigger room for growth, Sun said. “From this perspective, these are precisely the clients that will be able to bring support for the bank’s development in the future.”

Contact reporter Wang Yuqian (

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