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Fraser Howie: China's debt swap plan isn't the right solution for bad loans

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Zhou Xiaochuan, governor of the People's Bank of China, is glimpsed between cameramen during a news conference in Beijing on March 12.   © Reuters

When trying to figure out what is happening in China, the old adage of "watch what they do" rather than "listen to what they say" should never be forgotten.

     People's Bank of China Gov. Zhou Xiaochuan oozed calm on March 12, as he expressed confidence in the ability of the Chinese economy to sustain 6.5% growth this year and dismissed suggestions that there is a need for large-scale stimulus or a significant devaluation of the yuan. 

     But while he might have sounded unflappable speaking to reporters at the National People's Congress, the news that regulators are planning to allow banks to conduct debt-for-equity swaps to address growing non-performing loans -- confirmed at the meeting's conclusion by China Banking Regulatory Commission Chairman Shang Fulin -- tells a different story.

     No one should doubt Zhou's reformist credentials; he is probably the leading advocate of financial reform in China. His support over the past decade has provided cover for the limited meaningful improvements that have taken place. Yet he is far from an independent central banker and knows full well that he must play along with his political masters while also balancing the competing forces of bank management and the interests of state-owned enterprises.

     Debt-for-equity swaps are neither a Chinese invention nor a bad way to potentially work out soured loans, but in China there is a back story. In 1999, Zhou's patron, then-Premier Zhu Rongji, orchestrated the mother of all debt-for-equity swaps as a way to restructure what was effectively a bankrupt banking system. Four "bad banks," or asset management companies, were established, each paired with one of the four major state banks to buy their non-performing loans in bulk.

     The bad banks bought the loans at face value, with money raised from bond sales to the same state banks from which they were buying the bad loans. This creative accounting resulted in effectively clean balance sheets for the state banks, which could then be further consolidated in preparation for stock market listings, both domestically and overseas, in the following years.

     The plan worked well, as Chinese state lenders became some of the world's biggest banks by market capitalization. The cleaned-up banks continued to sell bad loan portfolios to the asset management companies, but generally at substantial discounts to face value.

     The bad banks set up operations across China and got started working out the thousands of bad loans. Some were sold on to other investors, but many were swapped for equity stakes and the businesses run as going concerns. As a result, the asset managers became significant non-bank financial institutions active in ventures ranging from stockbroking to property development. With a booming property market, the bad banks were able to turn around many dud deals and run an operating profit.

     Further financial creativity even allowed two of them to list: China Cinda Asset Management, the partner of China Construction Bank, and China Huarong Asset Management, the partner of Industrial and Commercial Bank of China.

TURF WAR?   What is odd about the new debt swap proposal is that the asset management companies seem to have been unaware of it and have no role in it. Yet they are at the very center of working out bad debts in China. Is this a banking turf war? Do the banks feel they can do better on their own? Are they trying to broaden their footprint by holding on to equity stakes and making a land grab of sorts? At present, it just isn't clear. There is no detail on how the debt-for-equity swaps will be priced or what percentage of non-performing loans would be handled in such a way.

     Who would win in this plan? The obvious winners would be the indebted companies. They will no longer have to pay back a portion of their debts, thereby reducing their leverage ratios and somewhat perversely making them more creditworthy and able to borrow fresh funds. What the banks would gain is far from certain.

     As the banking sector has continued to sell non-performing loans to the bad banks, the asset management companies have struggled to manage the workouts as the economy weakens and their own capital ratios suffer. Some investors had thought the bad banks would provide a hedge against a falling market and a weakening economy, but Cinda shares have fallen 25% since listing and Huarong 5%. That may be better than the recent market-wide performance, but well short of expectations.

     So why will the banks, newcomers to this technical and long-term game, fare any better than the asset management companies? If anything, the banks' balance sheets will become messier as they start to acquire blocks of equity at uncertain prices, although the regulatory commission's Shang reiterated that banks currently can't hold equity in non-financial companies directly. But what expertise in the non-banking sectors would the banks bring?

     China's banking sector underwent many years of reform, hard work and accounting magic to get into shape. The 2009 stimulus undid much of that, as the banks reverted to being credit taps that the government could turn on and off. This latest swap proposal goes further to make the banks political pawns, subject to industrial state interests.

     Much has been heard about supply-side management and reform of state-owned enterprises, both of which are essential to clean up the state sector, but the debt-for-equity proposal has all the makings of a short-term fix that will only make an already difficult and opaque situation worse. The debt-for-equity swaps worked well 17 years ago because China boomed in the subsequent years. The outlook now is very different, and stronger medicine is required.

Fraser Howie is co-author of "Red Capitalism: The Fragile Financial Foundations of China's Extraordinary Rise." He has worked in China's capital markets since 1992.

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