China's debt-to-equity swaps might have disastrous consequences, experts warn

Retail investors are at the losing end.

Chinese policymakers’ latest weapon against ballooning debt might dramatically backfire on an economy already struggling with slowing growth. Experts are raising their brows over China’s decision to allow its banks to convert over $150 billion of bad debt into equity, arguing that debt-to-equity swaps will have a negative effect not only on the banking sector as a whole but also on individual retail investors.

Fitch Ratings warned that debt-to-equity swaps will increase the risks in banks' portfolios, particularly because 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.

"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," the report from Fitch said.

More recently, Gordon Orr, board member at Lenovo and Swire Pacific, argued in an article that debt-to-equity swaps can be likened to just “moving losses from the left pocket to the right pocket”.

Orr noted that while state-owned banks and indebted state-owned companies may benefit from the move, individual investors stand to lose up to US$75 billion.

"[Debt-to-equity swaps] dilute the value of the remaining shares. The value of all the issued shares prior to the swap should go down. But small losses to many investors add up. If $150 billion of debt is converted to equity and, generously, that debt is really worth half of that, then investors are taking a US$75 billion loss,” he noted.

“That would even be large enough to show up as depressing the overall Shanghai market index, potentially requiring the government to intervene and buy more stocks to prop up the market,” he warned.

Not everyone is alarmed by debt-to-equity swaps, however. CCB analysts Lawrence Chen and Xie Yuan argued that the move is a solution and not a panacea, as it will help reduce debt levels while strengthening equity. They also noted that debt-to-equity swaps have proven effective in the past when it comes to cleaning up bank balance sheets, as highlighted by Japanese banks and Eastern European banks in the early 1990s and ASEAN banks in 1998-2003,

"We believe the Chinese government’s confidence that it can resolve the asset quality problems besetting the financial industry through DES deployment derives from the government’s earlier success cleaning up bank balance sheets through DES in the late 1990s and early 2000s," they said.

However, they also acknowledged that debt-to-equity swaps are inherently risky, particularly because the nature of current non-performing loans at Chinese banks are vastly different compared to NPLs in the 1990s.

“In our view, DES should be employed only in circumstances where simpler forms of debt resolution – extension of loan terms, renegotiation of interest rates, voluntary restructuring on the part of the borrower, etc. – are not practicable. In other words, DES should be viewed as a next-to-last resort, one step short of court enforcement of immediate borrower liquidation,” they said.