By Wang Gang & Bo Yan Research

Report Vol.20 No.5, 2018

Debt-to-equity swap is one of the important ways for enterprises to restructure their debts and lower their leverage ratio. Unlike the government-led, policy-oriented debt-to-equity swap at the end of the 20th century, this round of swap is a policy-guided, market-oriented business action taken by the creditors, mainly banks, and debtors to turn debt into equity for their respective interests on a voluntary and equal footing. The market-based debt-to-equity swap has made some progress since launched in October 2016 and helped steer Chinese enterprises’ leverage ratio from the upcurve to the downcurve[]①. However, as key supportive policies are absent, such as the policy-based compensation mechanism and the inefficient assets depreciation confirmation mechanism, institutions and enterprises are neither motivated nor able to carry out the swap. As a result, the completion rate of market-based debt-to-equity swap is only 8%. On the premise of insisting on market-oriented, law-based debt-to-equity swap, we should give better play to the government’s role. In the long term, we should improve the long-term mechanism of controlling SOE’s leverage, including the dynamic capital base replenishment mechanism, whereas in the short term, we should establish the inefficient assets depreciation evaluation and confirmation mechanism as soon as possible, and establish and improve the necessary policy-based compensation mechanism.

I. Progress so Far

In October 2016, the State Council issued the Opinions on Lowering Enterprises’ Leverage Ratio Actively and Properly and its appendix Guiding Opinions on Market-based Bank Debt to Equity Swap, which specified that the swap must be carried out in a law-based, market-oriented and orderly way. This lifted the curtain on this round of debt-to-equity swap. Progress made in the past year includes ever-improving , supportive policies and institutional arrangements, and the increasing diversity of institutions and business models involved.

1. Continuous improvement of supportive policies and institutional arrangements

Regarding institutional arrangement, on the central level, the State Council approved in October 2016 the establishment of the inter-ministerial meeting system for deleveraging work, with the National Development and Reform Commission (NDRC) taking the lead, as well as the system of ministerial-level “group meeting” and department-level liaison meeting that take place in turns every month. On the local level, by the end of 2017, 14 provinces, autonomous regions and municipalities, such as Shandong and Liaoning, had rolled out specific rules for implementing the policies issued by the State Council, and formed the debt-to-equity swap joint meeting system led by local development and reform commissions. As to supportive systems, the NDRC, Ministry of Finance and former China Banking Regulatory Commission (CBRC) successively issued policy documents (Table 1), setting down detailed provisions on the source of capital, implementing institutions, tax arrangement, plan, scope of targets and type of creditors’ rights for the swap. The executive meeting of the State Council held in February 2018 called for efforts to meet the signed volume of market-based debt-to-equity swap as soon as possible by creating more channels for private investors to make equity investment, strengthening the implementing institutions, and guiding the improvement of project quality.

2. Diversification of implementing institutions

(1) To date, the former CBRC has approved five large banks to set up new implementing institutions of debt-to-equity swap, and those of ICBC, ABC, BOC and CCB are already in operation. (2) Former CBRC issued a document that allowed willing provincial governments to form a new local assets management company. About 60 such companies are in operation across the country, constituting a crucial force in the market-oriented debt-to-equity swap. (3) Insurance institutions represented by China Life Asset Management Company Limited (CLAMC) are actively taking part in swap projects. As of October 2017, CLAMC had carried out five swap projects worth RMB50 billion in total, the clients including the Sichuan-to-East Gas Pipeline Project and China Shipbuilding Industry Company Limited.

3. Diverse business models, win-win results for banks and enterprises

Banks and enterprises have jointly created multiple ways of market-based debt-to-equity swap. Some of the signed projects adopted the model of “assuming debts first, swap later”, some “issued stocks to pay debts”, and some restructured the debts into three parts: remaining debts + convertible bonds + conditional equity swap. Following the Notice on Specific Policies Regarding the Implementation of Bank Debt to Equity Swap issued in January 2018, more swap options may appear that suit the enterprises’ actual situations.

Market-based debt-to-equity swap has been carried out for more than a year. In a macro sense, it helps steer the enterprises’ leverage ratio from upcurve to downcurve; in a micro sense, it lowers the leverage ratio and financial burden of some enterprises with bright prospects, so that they can “travel light” during the transformation and upgrade with obviously enhanced momentum. For instance, after the debt-to-equity swap project between CCB and Wugang Group was completed, the latter’s leverage ratio will be lowered by 10 percentage points, and the swap project between CCB and Yunnan Tin Group will help the latter create the world’s largest new materials base for tin chemical industry and achieve transformation and upgrade.

4. Steady increase of signed projects and sum

According to NDRC’s statistics, by the end of 2017, various implementing institutions had signed the framework agreement on market-based debt-to-equity swap with 102 enterprises, exceeding RMB1.6 trillion in total. These agreements involve the creditors’ rights of a number of banks, including ICBC, ABC, BOC, CCB, BCM, China Merchants Bank and Ping An Bank, and the agreement-signing enterprises are engaged in a wide range of industries including iron and steel, coal, transport, construction engineering, non-ferrous metals, chemicals, power and commercial services.

II. Problems and Causes

The biggest problem of market-based debt-to-equity swap is the low implementation rate. By the end of 2017, swap projects that had been implemented totaled more than RMB120 billion and the implementation rate was only 8%. There are many reasons for this. The swap involves a lot of transaction procedures, complicated structure and long period of negotiations and approval, and swap-implementing institutions have just begun operation and need time to fully play their roles. But the dominant reason is the lack of necessary policy-based compensation mechanisms, which dampens the wish and contains the capability of the implementing institutions to carry out debt-to-equity swap.

1. Lack of policy-based compensation mechanism is an important reason for the lackadaisical implementation

China doesn’t have a dynamic capital base replenishment mechanism for SOEs, which is an important institutional reason for their high debt ratio. Although the Ministry of Finance issued the Provisional Methods for Expenditure Management of Operating Budget of State-owned Capital under Central Management in 2017, only a little in the operating budget was allocated for capital base replenishment in the past three years, and no dynamic replenishment mechanism is established according to the increase of central enterprises’ total assets that are included in the budget (Table 2).

It’s obviously unreasonable to ask financial institutions that are in commercial operation and responsible for the shareholders’ interests to pay for SOEs’ existing or potential non-performing assets. Because of the lack of necessary policy-based compensation mechanism, financial institutions are not enthusiastic as there is no profit prospect, and there is even the practice of “nominal equity, actual debt”[② “Nominal equity, actual debt” means that financial institutions package their creditor’s rights into equity investment through repo or by promising constant return in order to meet regulatory requirements. As debt-to-equity business is risky and insurance funds and bank's wealth management funds pursue stable annualized return, implementing institutions, to attract third-party investment, usually have to make repo or valuation adjustment mechanism (VAM) arrangements. Under this model, neither the enterprises’ nor the banks’ risks are transferred, no party confirms losses, and the risk is just postponed rather than defused. The Notice on Specific Policies Regarding the Implementation of Market-based Bank Debt to Equity Swap issued by the NDRC allows the plan of “equity + debt” and recognizes “conditional, staged swap”, providing necessary guidance for the “nominal equity, actual debt” model. ]②. This is attributed to two factors.

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