Fitch: China Debt-Equity Swap Plan Would Be Negative for Banks
OREANDA-NEWS. A debt-for-equity swap plan, intended to alleviate mounting bad loans and financial pressures on Chinese firms, would be credit negative for the banking sector, says Fitch Ratings. Fitch believes that banks' ability to support such a plan in a large scale is limited given their slowing profit growth, rising credit costs and more stringent regulatory capital requirements. The extent of the impact on banks will depend on the details of the plan, including its size and the types of companies that will be allowed to participate.
Domestic and international media have reported that Chinese authorities are preparing a CNY1trn (USD154bn) pilot programme to exchange bank loans for equity. Such a swap would be equivalent to around 24% of Chinese commercial banks' (not including policy banks) NPLs and special-mention loans, or 1% of total domestic loans in the banking system. The scale of the reported swap plan would not be significant for the banking system as a whole, but if the programme were to be markedly scaled up, it could have a sufficient effect on bank assets and capital to be negative for bank credit profiles.
A debt-to-equity swap would increase risk in banks' portfolios. Equities have lower priority of claims relative to debt during the liquidation process and some bank loans have collateral, which can provide protection and mitigate losses in the event of default. Furthermore, while equities provide higher returns to compensate for risk, the returns are usually more volatile and dependent on company earnings and dividend policies.
Equity investments are also likely to have a higher risk weight than bank loans. As such, a large-scale debt-to-equity swap is likely to weaken banks' capital positions. Generally speaking, Chinese banks are not allowed to invest in equities of non-bank corporations, and China's banking regulator requires banks to apply a 400% risk weight on equity investments, which must be held for policy reasons and have special approval from the State Council. The higher capital requirement on equity investments may encourage the banks to move these exposures off their balance sheets or classify them differently through alternative credit products with more complicated transaction structures. This would reduce transparency and make it more difficult to assess bank risk.
More broadly, a debt-for-equity swap without fundamental improvement in borrowers' creditworthiness will only push back resolution of growing asset-quality pressures and enable risk to further accumulate in the banking system. To be sure, if companies are able to use the swap to improve their financial profiles and sustainability of their business models, then it could help to resolve the NPL issue and contribute to macroeconomic reform over the long run. As such, the types of companies that will be allowed to use the swap programme will determine to what extent it will have a negative effect on banks.
The level of state support provided for the programme could also be a factor in quantifying the effects on banks. The swap would reinforce the strategic importance banks play in maintaining financial stability and would underline the sovereign's strong propensity for support. However, it would also highlight the dilemma Chinese banks face between supporting policy directives and maintaining their standalone credit profiles.
It remains to be seen whether the authorities will also create a swap plan for corporate bonds. Such a programme would be much more complicated as bondholders for a given issue tend to be far more fragmented than bank lenders. A bond swap would also likely trigger significant uncertainty in the nascent domestic bond market. This would run counter to the authorities' efforts to build and deepen China's capital markets.