China just made a move to tackle the biggest threat to its economy, and it reeks of desperation

Reuters

This is usually the last stop before bankruptcy.

Chinese officials have told Reuters that they will start allowing commercial banks to swap nonperforming loans in super-indebted companies for stock.

That move is usually called a debt-for-equity swap.

From Reuters:

The new rules would reduce commercial banks' non-performing loan (NPL) ratios, and free up cash for fresh lending for investment in a new wave of infrastructure products and factory upgrades that the government hopes will rejuvenate the world's second-largest economy.

This is really striking. Nonperforming loans surged to a record high in 2015 of about $614 billion. Unproductive companies in struggling industries — mostly state-owned enterprises (SOEs) — continue to borrow, though, to pay back older loans.

This is dragging down the entire economy, and the government has little choice but to confront it. Until it does, China will not manage its transition from an investment-based economy to one based on domestic consumption. It will have to keep financing itself with debt.

This swap is meant to free up cash that can be invested in increasing productivity. That sounds good, but here's why it also looks desperate.

In 1999

China dealt with overwhelming corporate debt in 1999, about $200 billion worth of it. To solve the problem, the government just created a bunch of "bad banks" — which were really massive asset managers — to restructure the debt and sell it off. In a typical Chinese twist, those firms bought debt from corporates at full value.

That's a pretty sweet deal if you can get it, people.

And for a while that seemed like it was doing OK. Despite everything, the asset managers were able to eke out a profit on the debt through debt-for-equity swaps and other restructuring.

Then that stopped, and now the head of China's biggest bad bank is asking for help because it's drowning in NPLs.

Lai Xiaomin, CEO of China Huarong Asset Management Co., asked for a lifeline at China's National People's Congress this week, according to the WSJ. He's a delegate.

"The depreciating trend of bad assets not only poses a rising risk for asset management companies in acquiring assets, but also increases the difficulty of bad-asset disposal," Lai said.

He told Reuters that he's cheered up by the possibility of these swaps.

Reuters

Another thing about this is that if it's done properly, then it can't be done in great size. And if there's anything we know about Chinese corporate debt, it's that there is a large quantity of it.

True, by removing nonperforming loans from the books, the move will also free up cash that had been set aside as a buffer in case the loans defaulted. But equity is risky, and banks can't take on too much of that kind of risk.

Here's HSBC (emphasis added) referring to how much could be swapped before capital buffers, or Tier 1 capital, are depleted:

The big 5 banks have 1.8ppt and mid-sized banks have 0.5ppt buffer to capital requirement, assuming they keep Tier-1 at 0.5ppt above required. This implies potential room to do a one-off swap 2.2% and 0.6% of loans in the extreme case of completely depleting Tier-1 ratio buffer.

That's not going to really tackle this problem, but every little bit helps, right?

The Japan structure

Not if it creates a structure that will ultimately do more harm than good. That's what Bank of America analysts are worried about in this case.

Chinese banks aren't legally allowed to own stakes in nonfinancial companies. The government is going to make a special dispensation in this case, but should it?

"[B]y giving banks more 'flexibility' in dealing with their NPLs, we suspect that it may cause a more rapid accumulation of bad debt," the analysts wrote.

"This is using liquidity to paper over solvency issue in our view. As a result, we consider this unconfirmed new policy, if it comes to pass, to be a long term negative for the market, and particularly for banks and the Asset Management Companies (AMCs), aka the bad banks (due to reduced business scope). In the long term, we are also concerned about the potential forming of a banking-industrial complex in China."

Bank of America went on to say that it was a system like this that contributed significantly to the Japanese economy's loss of "vitality." If you know anything about Japan, you'll know that is an understatement.

There's another thing

Swapping debt for equity means that the banks will either be more exposed to China's equity markets, or have illiquid stakes in private companies they'll struggle to get rid of.

The government has never been shy about the fact that it controls the equity market. When China's stock market crashed twice during summer 2015, the government went in and kicked out the short sellers and collected scalps.

Even when stocks are rising, Beijing flexes some control and keeps new issuers from flooding the market.

That said, value is value. Thursday's trading day was a perfect example of this. The government did not intervene in the market toward the end of the day, and the market closed down 2.2% on the news that the government would try to cool property prices in Shanghai for the first time since 2012.

Analysts from Jefferies also blamed another signal of deflation, as the country's producer price index (PPI) came in down 4.9%.

"Either way the key read through from today was that when the market was allowed to trade on fundamentals then support was not apparent, despite the continued optimism towards fiscal support measures," the analysts wrote.

So there is some risk. We have to hand it to the Chinese government for introducing some moral hazard into the equation, but that's what it is — a hazard.

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