China’s Zombie State-owned Enterprises Benefit from Surge in Debt-Equity Swaps


Despite warnings from the central government China’s zombie companies have emerged as key beneficiaries of the debt-equity swaps used to slash leverage levels across the state-owned enterprise sector.

Debt-to-equity swaps have emerged as a central tool in China’s ongoing deleveraging campaign, with regulators availing themselves of the instruments to slash the debt burdens of ailing state-owned enterprises.

In China the swaps generally work by first allowing a bank to acquire the debt of a given company from its original lenders.

The bank then establishes a unit with other shareholders that assumes the debt, and conducts a transaction with the indebted company for the conversion of debt into equity, paving the way for its subsequent sell off.

According to figures from the National Development and Reform Commission debt-equity swaps have thus far proved effective at reducing the aggregate debt burden of over 70 SOE’s by 1 trillion yuan (USD$149.2 billion).

NDRC has also recently flagged the accelerated use of swaps to cut the debt levels SOE’s in the second half, referring to them as an “edged weapon” for deleveraging of the public sector.

The central government has expressed concern, however, about misuse of debt-equity swaps to keep moribund “zombie” SOE’s afloat, prompting the China Banking Regulatory Commission to introduce preventative provisions in the latest draft of the “Commercial Bank Newly Established Debt-Equity Swap Implementation Organization Administrative Measures (Trial)” (商业银行新设债转股实施机构管理办法(试行)).”

The new provisions moot a ban on debt-equity swaps for “enterprises that have lost credit because of malicious absconding from debt, enterprises whose credit and debt relationships are complex and unclear, and enterprises that do not satisfy national industrial policy, and spurred overcapacity expansions and increases in inventories.”

According to Natixis SA, the Chinese government’s concerns are justified, with its data indicating that 55% of swaps in the second quarter involved companies in the coal and steel sectors, which are amongst the worst afflicted by overcapacity.

A key example of this is China Construction Bank’s repackaging of the converted debt of Yunnan Tin Group and Wuhan Iron & Steel into wealth management products for sale to retail investors.

Natixis SA data further indicates that a large number of unsalvageable companies could be participating in swaps, given that the total value of the instruments surged to 776 billion yuan (USD$116.57 billion) for the second quarter alone.

According to analysts a big part of the problem is the lack of clear standards for defining and identifying zombie companies.

“China intends debt equity swaps as part of corporate de-leveraging and to help clean up bank balance sheets, but the list of deals announced so far suggests China’s definition of a good versus a zombie company is quite different from that of international investors,” said CreditSights analyst Matthew Phan to Bloomberg.

Debt-equity swaps could also be exacerbating the latent instability of the Chinese financial sector, with risk being foisted upon retail investors by banks who sell them wealth management products replete with converted debt.

Another problem is that debt-equity swap programs do not contain measures in and of themselves to improve the efficiency or performance of companies that use them to deleverage, which means they could again succumb to weakness.

“As a whole, I’m pretty skeptical about the debt to equity swap program and how effective it is at saving good companies,” said Phan.

“Bad loans have been bought partly by households but in five years’ time, the companies could be in trouble again.”