Will Debt-for-Equity Swaps Fail to Achieve Deleveraging?

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The use of debt-to-equity swaps to deleverage China’s immense state-owned-enterprise sector may be doing little more than shifting the debt load to other parts of the economy.

Since launching their usage roughly a year ago, the Beijing has repeatedly emphasised the importance of debt-to-equity swaps as a key tool for the restructuring and deleveraging of China’s huge and heavily indebted SOE sector.

The central government hopes that the instruments will prove an effective part of its efforts to deleverage the Chinese economy, by enabling heavily-indebted SOE’s to convert their debt in equity stakes for other finance providers.

Data from NDRC indicates that Chinese banks had already entered debt-to-equity swap agreements to reduce the aggregate debt levels of over 70 state-owned enterprises in the steel, coal, chemicals and equipment manufacturing industries by as much as 1 trillion yuan (USD$149.2 billion) as of August.

The central government may be undermining the effectiveness of swaps as a deleveraging tool, however, following the release a late-summer notice indicating that new bonds could be used to finance the swaps.

This will have the effect of simply moving debt from the balance sheets of the original creditors to investors in the new debt.

Bloomberg reports that the first swap deal to exploit the new rule was completed last month, when the Shaanxi province government established an asset-management company to raise debt to pay off the loans of heavily beleaguered Shaanxi Coal and Chemical Industry Group – lending which was slated for conversion into equity.

While Shaanxi Coal and Chemical will not have to worry about its debts in the wake of the deal, the burden will simply have been shifted to the provincial government’s new asset-mangement vehicle, potentially exacerbating the problem.

“If the funding comes from debt, it’s really not solving the issue here because the capital is not permanent capital,” said Christopher Lee, managing director of corporate ratings, S&P Global Ratings in Hong Kong, to Bloomberg. 

“In fact, you are adding more debt just to refinance the debt that was going to be swapped.”

The likelihood that debt will simply be shifted around could be further increased by the government discouraging the original creditors of beleaguered companies from pursuing swaps deals themselves to become owners due to concerns over conflict-of-interest.

The arrangement that regulators would appear to prefer involves original creditors first selling their debt to other entities, who can in turn finance such deals by means including private equity or bond issuance.

In the case of the Shaanxi Coal and Chemical deal, a China Lianhe Credit Rating report indicates that Shaanxi Financial Asset Management Co. raised 500 million yuan (approx. $76 million) via a private placement of six-year bonds.

Critics have also charged that debt-for-equity program is also undermining efforts to improve the efficiency of the economy by allowing ailing enterprises on the verge of demise to stay afloat.

Advocates of the debt-for-equity program point out, however, that it serves to diversify financial risk with respect to state-owned enterprises by attracting the participation of private players alongside local government.

As to whether or not swaps will help to deleverage the Chinese economy, analysts point out that this depends on whether the valuation of participating companies improves, allowing them to put to rest a greater amount of debt using equity stakes.

Should these companies – which in many cases are already under performing, fail to turn around their performance, then the end effect will simply be to shift bad debt from the public sector to private sector parties.

 

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