China’s Debt-for-Equity Swap Framework Provides Companies Time, Turnaround Plans Still Needed

China’s debt-for-equity swap framework provides near-term liquidity relief to Chinese corporates that need it, offering much-needed time to restore their business and credit profiles.

Still, these debt-for-equity swaps need to be combined with well-planned and closely monitored turnaround plans to allow companies to improve cash flow and recapitalize in order to avoid simply delaying default risk, according to a new report by Moody’s Investors Service. The report included an assessment of the debt-for-equity swap framework begun in October 2016. The Chinese State Council announced at its inception that the framework is designed to deleverage China’s corporate sector by expanding the number of parties eligible to execute such swaps and widens their funding channels.

"Furthermore, some swapped obligations remain as contingent liabilities in the system, and, in many cases, indebted corporations have to commit to buy back the equities created from the swap transactions after a fixed period; thus these equities are potentially more like fixed-income investments," said Clara Lau, a Moody's senior vice president.

Also, uncertainty remains as to who will finally eat the losses if the company fails to turn around, Moody’s said. "Execution entities—which can establish private equity funds and raise funds from third-party investors, such as wealth management products (WMPs), to invest in the debt-for-equity swaps—and their parent banks may need to bear the potential losses of these funds if exit strategies for the concerned companies do not materialize, as investors generally expect the banks to protect the principal and returns of WMPs," said David Yin, a Moody's vice president and senior analyst.

The swaps also bring risks for the banks, as, for example, it’s not clear if execution entities and their parent banks need to book their minority stakes in debt-for-equity swap investment funds on their balance sheets, or if they have to consolidate the funds in their entirety, including the stakes owned by third-party investors. "In the latter case, pressure on the funding profiles, capital adequacy and earnings stability of the parent banks will be material compared to the former case," said Yin.

The effects on corporates will vary, Moody’s said, depending on the structures of the transactions, and swap arrangements that are used to repay bank debt rather than fund new projects. Most of the affected companies are likely to use the funds to repay their outstanding debt in full, analysts said.

– Nicholas Stern, managing editor

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