China’s Debt-Equity Swaps – A Wake-up Call for Structural Reforms

01 Aug 2017

  • Debt-equity swaps have been a key strategy that Beijing uses to deal with bad loans and restructure the corporate sector. This market has flourished since inception. But evidence shows that it is not working properly.
  • This is because the scheme has been plagued by an incentive incompatibility problem between the new equity owners and the debtors that leads to adverse selection and moral hazard problems. The strategy will only work when the right incentive scheme is in place.
  • The failure of the debt-equity swap programme serves as a wake-up call for Beijing to pursue serious structural reforms. There is hope that this may happen in President Xi Jinping’s second term.

To tackle the non-performing loan (NPL) problem, Beijing asked the Big Five state-owned banks1 to set up asset management companies (AMCs) in 2016 to undertake debt-equity swaps. The move was reminiscent of the last attempt in 1999-2000 when Beijing set up four AMCs2 to take over RMB1.4 trillion of bad loans from the state-owned banks through various means including debt-equity swaps. The difference this time is that the AMCs are wholly-owned subsidiaries of the Big Five banks.

The debt-equity swap market has flourished since inception in Q3 2016, with official data showing that total swap deals grew from RMB30 billion to a cumulated RMB774 billion in Q2 2017 (equivalent to more than 16% of NPL3). The key targets for the swap programme are the highly-leveraged sectors with excess capacity, such as coal, steel, utilities and building materials, most of which are “zombie” firms (defined as inefficient firms that cannot generate enough profit for servicing their debt). Hope was high that this strategy would help China cut debt and restructure the corporate sector so that the number of zombie firms should fall.


However, evidence shows that this has not been the case. A recent market study4 of China’s 100 largest non-financial firms (by asset size) found that the share of zombie firms actually increased from 6% in 2015 to 9% of the total in 2016. Official data also shows that total liability of the industrial sector, where most large zombie firms reside, has continued to rise (Chart 1) and the asset-liability ratio has continued to fall. Many zombie firms have continued to live on borrowing and debt roll-over under the government’s implicit guarantee policy.

Meanwhile, small Chinese companies have seen a decline in zombies, as most of the small firms belong to the new economy and are market-driven and not protected by the implicit guarantee policy. Nevertheless, the emerging new economy is still too small to take over as the major growth driver of the economy.

With the current supply-side reform only focusing on industrial consolidation to increase the operating efficiency of the large and state-owned enterprises (SOEs), the debt-equity swaps will not be able to force exit of the large zombie firms because there is an incentive incompatibility problem inherent in the programme that creates more problems than solutions.

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