News Analysis: China looks to debt-equity swaps to reduce bad loan risk

To avoid bad loans bringing more trouble to an already ailing economy, China appears prepared to allow banks to exchange bad debt for stocks in the companies concerned.

The first planned group of debt-equity swap programs could help banks write off 1 trillion yuan (154 billion U.S. dollars) of non-performing loans (NPL) within three years, business magazine Caixin has reported, quoting sources familiar with a looming government plan.

Several high-profile speeches have been made recently by authorities hinting at a debt-equity swap mechanism. During the parliamentary session last month, Shang Fulin, head of the China Banking Regulatory Commission, said the government was "studying" the swap mechanism.

Meeting the press after the session, Premier Li Keqiang said China could "gradually reduce companies' leverage ratios" through "market-based debt-equity swaps." He restated the position at the Boao Forum for Asia last month.

These swaps are generally believed to benefit both banks and the struggling companies. They reduce the pressure on companies and free up bank balance sheets, releasing capital for investment.

Debt-equity swaps would be nothing new in China. In 1999, 580 companies swapped around 400-billion yuan of debt for equity, approximately a third of the total bad debt at that time.

NPL risk has been mounting. Last year, China's five major commercial banks saw a combined NPL increase of 239.3 billion yuan.

For one of these banks, ICBC, a 0.5-percent rise in net profits in 2015 compares starkly with a 5.1-percent increase the previous year. At the same time its NPL ratio rose from 1.13 percent in 2014 to 1.5 percent last year.

In short, bad debt is growing faster than profits. It is an even worse story at the Agricultural Bank of China where bad loans reached 2.39 percent last year, up from 1.54 percent in 2014.

While it is generally agreed that debt-equity swaps are a way to reduce NPL risk in the short run, they are not a magic cure for underlying problems.

"It's hard to be optimistic from a long-term perspective. Poor business performance is behind high debt, and debt swaps do little to improve performance," said Jiang Chao, analyst with Haitong Securities.

"Careful planning is needed before introducing pilot debt-equity swaps, the scale of which should not be too large. The prospects and potential of companies involved should be assessed by objective criteria," said Lian Ping, chief economist with Bank of Communications.

The Caixin report also said companies eligible for debt-equity swaps would be those in "temporary difficulties" with "long-term potential," instead of poor-performing "zombie enterprises" that will be phased out. Endi