A debt-equity swap will likely be a major part of the Chinese government’s strategy to deal with the country’s bad debt – that is IF we’re correctly reading between the lines of what was said at the recent National People’s Congress. In this Q&A, CEIBS Professor of Economics & Finance Xu Bin explains what this would mean for those buying China’s bad debt and suggests ways in which the government – within the framework of the country’s New Normal – can potentially pull it off.

Is there any significance to where and how this issue of a debt-equity swap was raised?
Xu Bin: In China everything is planned – where you sit, and after whom. So in that sense the words ‘debt-equity swap’, which were spoken by the translator during Premier Li Keqiang’s press conference at the last National People’s Congress, are very significant.

It is sending a very important signal. It’s like last time when Li Keqiang mentioned Free Trade Zone. It means that it was, at the very least, agreed by the top leaders that this would be one of the methods to deal with a very, very urgent and important issue – China’s debt.

So although the issue was not overly emphasised, the fact that it did appear in the two-hour press conference is extremely significant. So we should not read too much into the fact that it was only mentioned once, or that there is not a lot of discussion about it in Chinese newspapers. In Chinese, the words Li Keqiang used are not as ‘eye catching’ as the English translation [of] debt-equity swap. So I think there is a time lag in the Chinese media in terms of understanding the meaning and significance of this new policy design. But I anticipate it will come soon. Probably in a few months or a year, suddenly we will see it’s in all the Chinese media headlines that China is doing a debt-equity swap. Maybe Chinese people will invent an eye catching Chinese translation from the English words… 

If the government goes ahead with its plans, how will the swap be implemented?
Xu Bin: I think the debt-equity swap will take centre stage in resolving China’s bad debt issue. How it will exactly be done, we really do not know at this point. But I expect that it would be similar to what they did in 2002 to 2004.

At the time the official numbers for non-performing loans at China’s four major state-owned banks was very high, about 20%. So the whole world was worried about this issue. Then, the Chinese government was calling their solution ‘converting bad debt to bad or good equity’. Now it’s being called a debt-equity swap.

Back then the approach was to first separate the good and bad debts and put the bad debts into a separate company. The second step was to list those four major state-owned banks in China’s A Share market, and so they became equity shares. At the same time they invited strategic partners from major international banks and corporations – like Citibank, HSBC. Many of these big western banks benefitted a lot from their shares in these Chinese state-owned banks when they later listed, and some of them made a fortune by selling these shares during the global financial crisis.

So with that approach, the non-performing loan ratios of those state-owned banks became very low and they are now public companies – at least on the face of it – and their stocks are held as investments by foreign strategic partners.

These banks enjoyed a round of stock market price increase. And when China’s stock market crashed in 2007, the balance sheets of all these state owned banks were already very, very [healthy] by then. After that the state-owned banks’ non-performing loan ratio was about 1%; so I think that was a very successful way of converting the bad loans of state-owned banks to listed companies. The other aspect of it was that each of the four biggest state owned banks that went through this process had an asset management company to deal with its non-performing loans. I’m not an expert on how they dealt with that, but it was gradually absorbed. I think in the end it was indirectly absorbed by people, as the bad loans may be packaged and sold as investment products. So that is basically a successful way, and I anticipate that the same method will be used sooner or later by policy makers to deal with the sharp increase in bad debts – now this time held mainly by local governments. 

Are there any other methods the government is exploring of dealing with the debt issue and how do these methods stack up against the debt-equity swap approach?
Xu Bin: The government is also trying to convert local government bank loans into local government bonds. They have already initiated the plan of having the local governments issue bonds instead of borrowing from the banks. That’s a good step forward, because there will be a market for the bonds. In recent years the central government has deliberately allowed a few state-owned bonds to default so that was a lesson for the bond market and in that sense the bond market has improved.

But China’s bond market is still very under developed. So I don’t think converting local government bank loans to bonds is sufficient. I think it only can deal with a small share of China’s local government debt problem.

So it seems that the debt-equity swap would be the likely approach used to tackle the issue of local government debt. What are its pros and cons?
Xu Bin: It’s a swap, so the question is: between whom? That is going to be an issue.

The essence of this debt-equity swap is to shift the risk that is now concentrated in the hands of the government to a broader pool.  If it’s concentrated in the hands of government, that is a systematic risk. But if it is shared by companies and households, that risk is definitely less in [an] aggregate sense as each party holds a much smaller share. So technically it’s a very smart move.

However I worry about the distribution inequality side. By nature, these products will have an element of risk. Ordinary investors who do not understand these types of products should be very cautious in investing. I would be very much against packaging these bad loans in a very vague, unclear way then selling them in the market to people who do not have some knowledge of these kinds of instruments. This would be like ripping off the Chinese people, ordinary people who are presumably the owners of all state assets, according to the principles of socialism or communism.

However, I want to make it clear that the central government, Premier Li Keqiang, has very good intentions with this plan. It’s not a scheme to trick people. The government is basically trying to find a way to reduce the risk of China’s debt crisis, which is not only good for China but also good for the global economy. I am not against that method. I just think that it should be implemented in a transparent way, in a market-oriented way. That means making the prices right, and making the content right.

If you follow the rules of the market, some people like to take risk; some people have the ability to convert the government’s bad debts into good private equity. If you auction off a state-run company with a lot of bad debts, there may be some private companies who are willing to take the chance to run them. If they run them successfully, that would be a very successful debt-equity swap.

So it can be done in a transparent, market-oriented way. I would very much like to see this happen. I’m happy the government has made it clear that they are going to use this approach of a debt-equity swap. No matter how you interpret it, this is a first step. At least now we have an indication of the direction they plan to take.  This opens the door for better designing of their plan. If we look at the experiences of the past 2 to 3 years, the more you make government policy vague, opaque and not easily understood, the worse result you get.

With all the government’s good intentions, with all their good planning for the next 5 to 10 years, one thing we have to realize is that the New Normal is also about new ways of implementing policies. It’s about more transparency, more communication with people, with the market, and more discussions among scholars, more careful designing of methods. That is what’s going to increase the likelihood of success, which is desperately needed by both the Chinese economy and the global economy, which is faltering and hoping that China will pull it in a positive direction.

I think the government is learning how to be a better communicator. So, to be fair, we need to give them some time.

Is this debt-equity swap just a matter of pushing the toxic debt from one place to another without really addressing the underlying problem?
Xu Bin: That’s a very fundamental question. I think we have to look at it from several perspectives.

First, as I said before, diversifying is the right way to go as it reduces the amount of risk that’s concentrated in the hands of the government.

Second, there’s a chance that there’s a percentage of these bad debts that will be converted to good equity – if the conversion method is carefully designed. It’s a big if, but it is technically possible. Many countries have done it before. If we design a more market-oriented, more transparent, more long-term looking method and allow the private sector to be involved then I think there is a good percentage of that bad debt which can be converted to good equity.  So that’s point #2. I think that also should be recognised.

Then, point #3, there is still a part which will transfer hands but cannot really be transformed that easily from bad debts to good equity. So if they are converted they become bad equity. For that part I think the government should take more responsibility to absorb it in a transparent and fair way.

They should acknowledge that this part is because of bad decisions made in the past. Even the private sector makes bad decisions and their stakeholders lose money as a result. So as long as the government has really done its best and acknowledges that that part of the debt cannot be recovered, then they should just put it on their balance sheet as a loss. Then the loss will be absorbed maybe within 1, 2 or 3 years. But they need to make it transparent. Every year there is the National People’s Congress, which is sort of a look at their balance sheet. They can just let the country know, through the NPC, that due to certain mismanagement they lost a percentage of their investment in certain projects. I think the people of China would very much appreciate this honesty. Everybody makes mistakes; but trying to hide them, trying to evade taking responsibility, that is not suitable under China’s New Normal.

If we interpret the New Normal more broadly, it should be a new way of running the country.

Point #4: in writing off these bad debts we should really do it in a fair way. We will probably have to ask the big monopoly state-owned companies to share a larger part of the burden. They should share the burden with the government; but this allocation should also be done in a transparent, market-oriented way. It should not be the central government ordering them to buy the bad debt. But there has to be some allocation among all the state owned enterprises.

So overall I think a debt-equity-swap would be a move in the right direction but we have to watch carefully how it is implemented. I really hope that the Chinese government will promote the New Normal approach in solving economic issues. That, in my view, is the most important element of the New Normal concept. It’s a very positive concept. Now we understand it very narrowly, only in terms of a slower rate of economic growth, which sounds very negative. We should give the term New Normal new meaning, new life, in the context of this discussion about dealing with the debt-equity swap.

If this current leadership can really lead the Chinese people towards that kind of New Normal they will have their names [written] in history [books].

Exactly how much bad debt are Chinese banks holding? How does it compare to the rest of China’s debt?
Xu Bin: Nobody knows the exact amount of bad loans that China’s state-owned banks are holding. But I think it is safe to say that the number is significant. China has relied so much, in the past, on fiscal stimulus and monetary expansion to achieve GDP growth goals. But fiscal stimulus means borrowing, so that generated a lot of government debt especially during the global financial crisis of 2008-09. I think during those 2 years the amount of debt accumulated by the government was more than the amount of debt it had accumulated in the previous 30 years.

However, if you look at the official statistics, even if you add the local governments’ and the central government’s debts together, it’s only about 56% of China’s GDP. Now I know there has been a lot of discussion about the reliability of China’s economic data. In my personal view, they are reliable. But we do need to pay attention to China’s classification when we read the country’s data, which is sometimes quite different from the standard international classification.

In terms of China’s debt ratio, one thing we should note is that China’s corporate debt ratio is very, very high. It’s probably 120% of GDP. Among these corporates there are many that are state-owned and state-related. So if you just make a very simple assumption that half of this corporate debt is state-owned corporate debt and they should be classified as government debt, then half of 120% is 60%. That 60% plus the [other] 56% [of central and local government debt] is over 100%. That is really a huge debt ratio.  So I think the hidden risk of China’s debt problem is huge. It’s comparable to the European debt crisis situation, but of course with a caveat that the Chinese central government’s balance sheet is still relatively sound. China has a very strong, very rich government, so it is able to overcome this debt problem. Also, the risks on this side are mainly domestic debt. Yes we do have a certain amount of international debt but it’s not above the threshold of safety.

So we have to remember two things: one, China’s debt ratio is very high, comparable to many debt crisis countries.  Second: China’s probability of having a debt crisis is low because the government has a lot of resources. I think these two points are consistent with each other, so when we look at China’s debt issue we should bear both points in mind. The problem is significant; however it’s not at crisis level because of the [strong] asset side. 

Posted April 6, 2016