When it was announced in October 2016, Beijing’s plan to expand debt-for-equity swaps into the private sector was hailed as the ultimate solution to China’s notoriously onerous corporate debt problem.
Nearly 18 months on, the impact is yet to be seen.
China Inc’s non-performing assets have shown no sign of shrinking, rising to over Rmb1.7 trillion ($270 billion) as of the end of last year from Rmb1.27 trillion by the end of 2015, according to China Banking Regulatory Commission.
Still, it is just a matter of time before Beijing's debt-for-equity swap initiative proves a success, provided it can improve the regulatory environment so more deals can be closed.
That is the view of Lai Xiaomin, chairman of China Huarong Asset Management, the country’s largest distressed debt manager, which manages more than half of the nation’s outstanding problematic debt and is seeking to drum up investor interest for an initial public offering in Shanghai. Lai was speaking some weeks before China's anti-corruption watchdog announced late on Tuesday that it was investigating Lai for suspected "serious violations of laws and discipline".
“It is an old business but at the same time it is a new business,” Lai said as he spoke to FinanceAsia again last month, two and a half years after the company was floated on the Hong Kong Stock Exchange.
By "old business" Lai was referring to the fact Huarong has been undertaking debt-for-equity swaps ever since it was established in 1999. For a long time it was involved principally in policy-driven, government-instructed programmes for strategically important state-owned enterprises, mostly in the financial sector.
However, it is also involved in a "new business" after the government expanded the scope of debt/equity swaps to allow greater private-sector participation in October 2016, altering the market landscape and bringing new challenges to asset managers.
THE CHALLENGES
“The biggest change is that the government used to pay the bills [to back all the swaps financially],” Lai told FinanceAsia. “But under the new programme, banks and asset managers could suffer their own losses if they fail to execute the deals properly.”
In practice, swap deals are no longer assigned by the central bank. Commercial banks, asset managers and trust companies are required to source their own deals and they compete with other market players, while bearing all the risks throughout the target company’s turnaround process.
These market-oriented swaps are potentially beneficial to financial institutions because they can earn significant profits by picking the right deals. But before that, they need to invest more resources into deal-sourcing and to improve their risk-management standards.
Execution is another problem facing the growing debt-for-equity market.
“There are a lot of talks about swaps, but not many deals have been executed,” Lai said, pointing out how over Rmb1 trillion ($159 billion) of market-oriented swap agreements have been signed under the new programme, but only Rmb300 billion worth of deals are in the process of execution.
Last year, Huarong executed Rmb15.9 billion-worth of debt-to-equity swaps. It was among the eight financial institutions behind Aluminium Corporation of China’s Rmb12.6 billion swap deal – a landmark transaction that helped reduce the leverage of a fundamentally sound but financially-struggling company riddled with overcapacity.
However, the overall amount remained relatively small compared with Huarong’s Rmb1.87 trillion of total assets and Rmb930 billion of distressed assets under management.
REGULATION AND ALLIANCE
Banks and asset managers are turning more cautious to swap deals because the Chinese market lacks relevant regulations governing the swap process, including a unified mechanism for pricing, exit, and asset transfer, among other things.
Lai sees Beijing’s recent decision to merge the banking and insurance regulator as the first step towards establishing a regulatory framework for the swaps market.
“The merger [between China Banking Regulatory Commission and China Insurance Regulatory Commission] will result in better scrutiny of the market because banks and insurance funds will no longer be regulated by sector, but according to their functions,” Lai said. “It fits well with the trend of companies operating under an integrated business model.”
At the same time, Lai believes a strategic alliance between the country’s so-called “Big 4” distressed debt managers – Huarong, Cinda, Great Wall, and Orient – could benefit the development of China’s ever-growing asset management market.
Currently, the four state-owned groups manage over 90% of the nation’s distressed assets.
Huarong is strengthening itself ahead of a foreseeable boom in debt-for-equity swaps and other asset management businesses. It's looming IPO could yet raise about $4 billion and provide it with more capital to acquire distressed assets.
Lai expects the A-share listing to be completed by the end of this year.
This article has been updated to mention the investigation into Lai by the Central Commission for Discipline Inspection.
