New York (Bloomberg) - Almost a year after China rolled out steps to rein in soaring corporate leverage, concerns are rising that undeserving companies are benefiting while households are getting saddled with risks.
China unveiled guidelines for debt-to-equity swaps in October, part of measures to trim the world’s biggest corporate debt loads. The idea was that healthy firms would use the program to cut interest-bearing borrowings, while bloated companies would be shunned. But it hasn’t always worked out that way, even as the total value of swaps reached 776 billion yuan ($116.3 billion) in the second quarter when volumes jumped to a record, according to Natixis SA.
While China’s State Council said in October that zombie firms may not take part, 55 percent of the swaps last quarter were in the coal and steel industries, which are plagued by overcapacity, Natixis says. The stakes are high for lenders and even individual investors, some of whom buy wealth management products repackaged from the swaps.
The absence of a clear definition of "zombie” is part of the problem, according to Fitch Ratings. Views vary on whether further guidelines on the program released this month by the banking regulator will help address these issues.
The program is attracting bad companies because they see debt-to-equity swaps as a way to get a bailout, said Chi Lo, Greater China senior economist at BNP Paribas Asset Management. "You can imagine the zombie companies will be just like cancer cells that eat into the system.”
The swaps generally work like this: A bank agrees to take over a company’s debt from its original lenders. The bank sets up a unit which has other shareholders that help share risk. The unit assumes the debt and conducts a transaction with the company to convert it into equity. It can then dispose of the stake.
In the most recent draft guidelines released earlier this month by the China Banking Regulatory Commission, a bank is required to own no less than a 50 percent stake in the unit conducting the swaps. The guidelines also say that the units can sell bonds and borrow from the interbank market.
Before the bank units dispose of their equity stakes in the companies, they may struggle to manage them, according to Victor Jong, a partner at the business recovery services unit of PricewaterhouseCoopers LLP in Shanghai.
Among struggling companies that have signed swap agreements are Sinosteel Corp., which received support from the Chinese government to avoid defaulting on its debt in 2015.