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November, 201810:54 PM



Thoughts on China: Swapping Debt-for-Equity

Thoughts on China: Swapping Debt-for-Equity

Attention of late has turned back to Australia?s largest trading partner, China, as it has been forced into a trade war with the US.

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10.07.2018 05:19 PM

Attention of late has turned back to Australia’s largest trading partner, China, as it has been forced into a trade war with the US. This centres around intellectual property, questions about the future of the current growth cycle, and the issue of capital flight. 

From my perspective, these are short-term issues, and ones that will impact in some capacity as the political risk collides with economic risk. However, the major reasoning for the current movements in Chinese markets is the financial stability programme enacted in late 2016 by Beijing, and specifically, the deleveraging of state-owned enterprises (SOEs).

This is one of President Xi’s top priorities. The state of overleveraged enterprise in China is legendary, and a key risk to one of the President’s other top priorities, ‘made in China by 2025’.  

China is undertaking several measures to structurally ‘deleverage’ its enterprise markets, including a debt-to-equity swap program initiated in late 2016, supply-side (capital supply) reform, and a new round of SOE legislation.

An example of Beijing’s want for this program to work can be seen in the recent changes to the reserve requirement ratio (RRR) from the People’s Bank of China (PBoC). A significant quantity of capital released from this program is designed to support the debt-to-equity swap program.


The nuts and bolts of the debt-to-equity program

This isn’t the first time the China has undertaken a program of this kind. In the mid-90s, the first debt-to-equity swap program was enacted, however, it was heavily controlled by the Government, meaning the delivery of funding sources and ‘refinanced’ firms were chosen and controlled by Beijing. 

The new program is more ‘market-based’, especially with respect to the funding sources. 

Here is a relatively simple view of the program:

1. ‘Participants’ in the equity swap inject capital into a newly created ‘development fund’. Participants include banks, asset management companies, insurance firms, state-owned capital operations, private equity firms and wealth management plays. 

2. The ‘development fund’ then takes an equity stake in the ‘target’ firm (refinancing firm) with the funds raised from the participants.

3. The funds from the equity injection are then used to repay loans held by its bank. Interestingly, this could mean a bank might actually be a participant that contributed to the ‘development fund’. 

Thus, this completes a debt-to-equity swap. Structures do vary, but in the main, this is the core process. 

The other structure is the development fund purchasing debt from the bank (or banks in some cases) and swapping out the debt for equity. This way, the ‘target’ firm’s debt-to-assets ratio (the leverage ratio) is reduced and this lowers the risk.

The program clearly spreads risk from the firm to the broader financial environment, and therefore, isn’t perfect. But the program does reduce debt repayment burdens and aligns investment. In saying that though, the program's uptake has been rather slow so far as there is a negative effect on capital, added to the fact there is a limited amount of low-cost funding sources.  

However, considering the high priority the debt-to-equity swap program has been given, it is likely to accelerate in the coming months for the following reasons:

1. This is probably the lesser of all evils in undertaking a program of this magnitude, and the most effective way for Beijing to keep macro-gearing under control over the coming years.

2. China has also seen a sharp rise in corporate defaults over the past six months, which appears to have been a catalyst for the Government to ramp up the program.

The first round of cuts to the RRR, in my opinion, are likely to be the beginning of a concerted effort by China to ramp up the debt-to-equity program to offset downside risks for the Government, deleverage SOEs, and provide a buffer to future growth risks. However, the consequences to market-based mechanisms (e.g. listed markets) will be negative, as the already elevated multiples in Chinese stocks will have the drag of poor return on capital. 

All this helps explain the structural changes to Chinese markets and goes some way in explaining why the Shanghai and Shenzhen composites have recently entered bear markets. There are clearly other factors at play, the movements in the renminbi (CNY) case in point, as the devaluation starts to spark fears of the return of currency wars. But, for now at least, China appears to be controlling the current movements for future longer-term gains.    

Published by Evan Lucas, Chief Market Strategist, Invest Smart
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