A ¥1 trillion ($154bn) pilot programme proposed by China’s banking regulator to convert the severest debts of non-financial companies into equity has met with stiff opposition from ratings agency Fitch.
As The Treasurer previously reported, financial authorities in China are struggling with a boom in non-performing loans (NPLs), with national corporate debt at its highest level for 10 years.
During a parliamentary session in March, Shang Fulin – chairman of the China Banking Regulatory Commission (CBRC) – suggested that debt-for-equity swaps would be a workable method to “progressively reduce corporate leverage”.
Under the proposal, NPL obligations in select cases would be converted into stock holdings: a scheme that would enable authorities to instantly reclassify a portion of China’s bad-debt burden.
Given the obvious appeal of that solution, the plan found favour with Premier Li Kequiang, who confirmed at a Hainan conference of government officials and business leaders on 24 March that debt-for-equity swaps were being seriously considered as an economic solution. The issue has remained live ever since.
However, in a 19 April opinion, Fitch warned that the scheme would place significant stress on China’s banking system if it were extended too far beyond an initial remit.
Fitch wrote: “Such a swap would be equivalent to around 24% of Chinese commercial banks’ (not including policy banks) NPLs and special-mention loans, or 1% of total domestic loans in the banking system.
“The scale of the reported swap plan would not be significant for the banking system as a whole – but if the programme were to be markedly scaled up, it could have a sufficient effect on bank assets and capital to be negative for bank credit profiles.”
It explained: “A debt-to-equity swap would increase risk in banks' portfolios. Equities have lower priority of claims relative to debt during the liquidation process and some bank loans have collateral, which can provide protection and mitigate losses in the event of default.
“Furthermore, while equities provide higher returns to compensate for risk, the returns are usually more volatile and dependent on company earnings and dividend policies.”
Fitch warned that equity investments are also likely to have a higher risk weight than bank loans. With that in mind, a large-scale debt-to-equity swap could end up weakening banks’ capital positions.
“Generally speaking,” the agency wrote, “Chinese banks are not allowed to invest in equities of non-bank corporations, and China's banking regulator requires banks to apply a 400% risk weight on equity investments, which must be held for policy reasons and have special approval from the State Council.”
It added: “The higher capital requirement on equity investments may encourage the banks to move these exposures off their balance sheets or classify them differently through alternative credit products with more complicated transaction structures. This would reduce transparency and make it more difficult to assess bank risk.”