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

Firemen on motorbikes in front Tiananmen, Beijing. (Photo by Etienne Oliveau/Getty Images)

Usually, this is the last stop before bankruptcy.

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

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. Non performing 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 back 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 managed to eke out a profit on the debt, through debt-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,” Mr. Lai said.

Lai told Reuters that he’s cheered by the possibility of these swaps.

Another thing about this, is that if it’s done properly 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 non performing 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 ours) 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,” HSBC analysts wrote after the news was announced (emphasis ours).

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 hurt, that’s what Bank of America analysts worried about in this case.

Chinese banks aren’t legally allowed to own stakes in non-financial companies, the government is going to make a special dispensation in this case — but should it?

“…by 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” — an understatement, most certainly.

There’s another thing

Swapping debt for equity means that the banks will now be more exposed to China’s equity markets.

The government has never been shy about the fact that it controls that market. When China’s stock market crashed twice during the summer of 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.

NOW WATCH: Why 2-in-1 shampoo and conditioner products don’t work

NOW WATCH: Money & Markets videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at