Oct 21, 2016 | 09:00 GMT

4 mins read

Beijing's Debt Swap Program Takes Shape

Beijing's Debt Swap Program Takes Shape

China is ramping up its campaign to rehabilitate ailing state-owned enterprises. On Oct. 10, China's Cabinet published new guidelines for the debt-to-equity swap program Beijing unveiled earlier this year. A week later, Chinese news outlet Caixin reported that Yunnan Tin had become the first provincial state-owned enterprise to put the framework into practice by striking a debt swap agreement with China Construction Bank, one of China's "Big Four" state-controlled banks. Several other enterprises will likely soon follow Yunnan Tin's lead; China Construction Bank has reportedly begun talks with at least 50 companies. Though Yunnan Tin's precedent sheds light on many aspects of the debt-to-equity swap protocol, it does not clear up the fundamental questions of how and why companies are selected for the program. 

By and large, the Yunnan Tin agreement conformed to Beijing's new guidelines. In accordance with the prescribed procedure, the deal stipulates that a subsidiary of China Construction Bank will set up a joint fund with Yunnan Tin to raise investment capital in two rounds worth 5 billion yuan (about $741 million) each. China Construction Bank itself will chip in only a small sum to the fund. Most of the money will come from investors, wealth management products, China's four major asset management companies and the National Social Security Fund. Once the fund has reached its 10 billion-yuan target, Yunnan Tin will repay an equivalent sum in outstanding loans to its primary creditors.

The only component missing from the Yunnan Tin swap is the independent "implementing agency" that the guidelines describe, though its absence likely indicates that the government has not had time to establish one. According to the guidelines, the agency would be at the helm of debt-to-equity swap deals, assessing conversion prices and other conditions for the swaps, raising funds for the equity stakes, and handling the sale of a company's equity shares to outside investors. Perhaps more important, the agency is in charge of helping banks suss out which companies merit assistance and which are too far gone to help. In the absence of such an arbiter in the Yunnan Tin agreement, it remains unclear just what criteria are used to select candidates for debt-to-equity swaps from among China's many foundering state-owned enterprises.

Yunnan Tin is neither exceptionally dysfunctional nor unusually undeserving of government assistance. It has, however, had its share of upsets. In 2013, the group's previous chairman was detained on corruption charges and given a suspended death sentence, according to Caixin. His predecessor, who ran the company from 1998 to 2008, is now one of the Chinese government's 100 most-wanted overseas officials. Beyond its legal difficulties, the company is also no stranger to financial trouble. In fact, Beijing has already bailed out Yunnan Tin once before. During its last major round of debt conversions in 1998-99, the government transferred a trillion yuan in nonperforming loans to its four asset management companies to save the Big Four state-owned banks from collapse. As part of that process, two of the asset management companies bought undisclosed stakes in Yunnan Tin. Today, the company has a debt-to-equity ratio of 83 percent, well above what is generally considered healthy for businesses. All things considered, Yunnan Tin seems an unlikely candidate for the market-driven debt swap program that Beijing's recent guidelines delineate.

Doubtless, the company's position as the dominant tin producer and exporter in China, and one of the largest state-owned enterprises in Yunnan province, factored into its selection. Yunnan Tin's scale alone makes it a relatively safe investment for major institutional investors, insofar as Chinese authorities will not likely let it go bankrupt. Since the swap could help Yunnan Tin reform itself into a sustainably profitable enterprise, it does not necessarily contradict Beijing's stated intention to build a debt-to-equity swap program driven by market forces. Still, the Yunnan deal raises questions as to how Beijing will realize that goal, particularly at the local and provincial levels, where the need to maintain employment and social stability often outweighs matters of economic efficiency and profit. And unlike the bailouts of the late 1990s, which the government and the Big Four banks funded directly, the proposed debt conversions will draw capital from sources that promise their investors high return rates, such as wealth management products. Consequently, the financial risks of letting factors other than economic potential decide which firms will receive the debt swaps are much greater.

As other debt swaps come to light, Yunnan Tin may prove an outlier. Once the implementing agency has been established to take over the deals as promised, market forces could dictate the selection of enterprises for future debt-to-equity swaps at the local, provincial and central levels of government. At the very least, the program will help lower the costs of servicing the state-owned sector's heavy debt burden — which makes up over half of China's corporate debt — ideally freeing up capital for state-controlled businesses to boost investment in the process. Nevertheless, it remains to be seen whether the program will advance Beijing's quest to subject China's economy, and its myriad underperforming state-owned enterprises, to market forces, or whether it is merely a palliative measure. 

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