PBOC's Coming Cash Dump Is Slow-Burn Debt Fix, Not Market Rescue

(Bloomberg) -- China’s latest monetary policy move, due to take effect July 5, won’t do much for investors seeking respite from a falling stock market or a slumping yuan.

500 billion yuan ($75.7 billion) out of 700 billion yuan freed up by a cut in reserve-ratios announced June 24 is intended to assist banks in funding debt-to-equity swaps -- a key plank of the nation’s effort to reduce risks in the financial sector that until now has seen disappointing take up.

Use of the funds will be slow as banks have to carefully choose company targets, according to Iris Pang, Greater China economist at ING Bank NV in Hong Kong. That suggests that much of the newly-released money will remain unused for a long time, she said.

The initiative works by converting soured loans into equity stakes, meaning that companies in theory can lower their leverage and reduce interest expenses, while banks can improve their asset quality. China’s five biggest banks had agreed on swap programs worth 1.6 trillion yuan by the end of 2017, but only around 20 percent of these had been executed, according to China International Capital Corporation.

Here are the major hurdles in the way of reviving China’s debt-equity swap program:

Higher Risk and Capital Requirements

A debt-equity swap means that the bank or investor takes on more risk. Compared to loans, banks face substantially higher capital requirements if they own a share of a commercial entity.

A normal loan has a risk weighting of 100 percent, and non-performing loans are weighted at 250 percent. By comparison, for the first two years that a bank holds equity, the risk weighting is 400 percent, and this jumps to 1,250 percent from the third year.

If China’s lenders were to use the whole 500 billion yuan for swaps, their risk-weighted assets would increase by 2 trillion yuan in the first two years and 6.25 trillion yuan from then on, according to analysts at Shenwan Hongyuan Group Ltd.

Asset Management Skills

The 2016 plan tries to make sure the swaps are market-oriented, requires the involvement of public investors and also demands that banks set up an asset management subsidiary to arrange the swap on their behalf.

Establishing more asset managers "would consume banks’ capital and cannot be solved directly by the liquidity release from an RRR cut," Wang Tao, chief China economist at UBS Group AG in Hong Kong, wrote in a report.

"It’s unclear if commercial banks have enough knowledge, skills and the human resources" to select qualified companies, calculate swap ratios and take part in corporate governance as a board member, said Lu Ting, chief China economist at Nomura International Ltd in Hong Kong. "While the idea is good, there are many difficulties in real operation."

Previous Bad Experiences

Part of the reason for the slow takeup may be bad memories of the last time this tactic was tried. Swaps are a "painful" process that should only be used when there’s no other choice, according to Yang Kaisheng, an adviser to China’s banking and insurance regulator who led China’s first round of swaps in the late 1990s to write-off bad debts.

Yang was president of China Huarong Asset Management Co, which converted the debt of 281 state-owned enterprises into equity in 1999. The company still held stakes in about 190 of them by June 2017, according to Guotai Junan Securities.

©2018 Bloomberg L.P.