China's evolving bank restructuring: From loan-to-equity to loan-to-convertible bond swaps

It has been two years since Chinese banks have seen their luck turn sour with raising NPLs and decreasing profits. Preoccupied by other issues – including the collapse of the stock market and a huge loss of reserves after a mini-devaluation – the Chinese government only turned to the banks' situation early this year. Most of the actions taken have been piecemeal and uncoordinated.

However, there was one measure introduced last February that did stand out given its size and its "audacity", namely the loan-to-equity swap in which RMB 2.75 billion in bank loans from Huarong Energy, a large shipping company, were converted into equity, making Bank of China its largest shareholder.

While the deal may have looked great at first, in terms of hiding the NPL problem under the carpet, the market soon realised that it would be extremely costly in terms of capital needs if it were to be generalised beyond one single deal. Meanwhile, urgent cases of corporates unable to meet their repayments have been piling up. The best known case is probably SinoSteel.

After missing several payments (coupon and principal), the Chinese authorities have finally decided to tilt the strategy followed for Huarong Energy into a less capital-intensive one, namely a loan-to-convertible bond swap which has followed an initial capital injection by central SASAC.

The key is that banks having granted loans to ailing SinoSteel can get them off their balance sheets without immediately becoming the owners and without hugely increasing their capital needs. Loan-to-convertible bond swap is clearly a better instrument for banks but still worse than a loan, so banks only got their way halfway. Here are the reasons:

As far as capital is concerned, there is nothing worse than a loan-to-equity swap. A convertible bond can still eat up capital but only further down the road. If the banks' claim on SinoSteel were to remain as loan, the ensuing capital needs very much depend on the level of non-performing loans and provisioning and the need to write off, and therefore it is hard to compare.

Looking into profitability, the loan-to-equity swap would still be the worst of all as a dividend payout would be very unlikely. However, the new scheme is still worse than a loan which you can write off at a certain point and the implicit return of the bond coupon will be lower than the loan.

Finally, for liquidity purposes, the loan-to-convertible bond is clearly the best option as there is a higher chance that the coupon will be paid (even if with a lower return) and the provisioning will be freed if the loan was classified as non-performing loan before the swap took place.

The new model of corporate debt restructuring introduced with SinoSteel's case has a number of important implications. Firstly, the central government has given up on banks' taking the lion share of the cost to clean up excess leverage and has preferred to share that among the three major stakeholders, namely the government, the corporate, and the banks.

Secondly, given the fairer burden sharing of the new initiative, we expect it to be implemented more generally, as opposed to the loan-to-equity swap which would have been too costly. This new scheme offers breathing space for banks but the clock keeps on ticking. In the medium term, unless rescued companies become profitable again, Chinese banks will need to raise capital.

Thirdly, the next corporate to come will probably be similar to SinoSteel, namely within the overcapacity sector and probably under SASAC so as to afford the initial capital injection.