China’s debt is beyond worrying. It’s credit-to-GDP gap, a measure employed by the Bank of International Settlements (BIS) as a way to gauge debt levels, stands at 30%. This is the highest of any country going back to 1995 and is three times the threshold the BIS uses as an early sign of unsustainable debt.
The government has a plan to help ailing companies burdened by heavy debt levels. They will be allowed to give their creditors equity stakes in their companies in return for reducing debt. But while this may seem like a solution to the growing debt crisis, it is no more than a temporary lifeline.
China needs real market reform to avoid a debt crisis. Companies undergoing difficulties need to be restructured, hard budget constraints imposed, and losses and unprofitability revealed.
Buying time for zombies
The problem is China’s “zombie companies” - state owned corporations (SOEs) that operate in industries that are over capacity and have poor growth prospects, such as steel. For political reasons these companies can’t be shut or allowed to fail. The zombies are only kept afloat through loans (often at below market rates) from the state-owned banks. They have no prospect of repaying these.
This is where the plan comes in.
China is attempting to restructure some of the zombies by allowing them to swap their bank debt for an equity stake in the company. But this loan-relief plan is only designed to alleviate pressure on the companies, by lowering the cost of servicing debt for those undergoing temporary hardship.
The guidelines for the swap emphasise they would be market orientated. But there is no clear reason for a bank to want an equity stake in a company facing difficulties, nor for an SOE with only temporary cash flow issues to part with valuable ownership stakes.
These kinds of swaps have been done before, but not like this
Converting debt to equity is a technique that has worked in other countries but could deepen the debt problem if used by China’s zombies. In its current form it is little more than buying some breathing room for the SOE and transferring the risk to the bank.
It is essential that the new equity comes with some control by the entity receiving equity, so they can reform the zombies. The proposed debt for equity swap appears to be a temporary measure only, and there is little detail on whether the asset managers gain any control or can push through a reform agenda.
Further, the debt for equity swap will be facilitated through asset management companies which are predominantly subsidiaries of the state owned banks. It is unlikely that they would have any more skill in managing these assets than the banks do. Unless there is a clear change in the corporate governance and transparency of the SOEs then there is little likelihood of change.
There needs to be real reform
This is some hope that China is moving ahead with some reform measures. A number of planned debt to equity swap plans have been successfully rejected by creditors. Dongbei Special Steel, for example, was forced into bankruptcy by creditors. And there has also been a sharp rise in the number of SOE defaults. But the heart of the debt problem needs to be addressed.
The International Monetary Fund has suggested a comprehensive reform strategy involving identifying companies with difficulties, recognising losses and burden sharing. They specifically note that restructuring SOEs and imposing hard budget constraints is vital to the reform.
However this reform will be expensive both politically and economically and will likely result in slower growth and great volatility in the financial markets. The debt-for-equity swap program is a temporary measure where a real solution is needed. Unless China undergoes tough reforms it is heading for a hard landing.