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As China tackles corporate debt, risks spread wider

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China's plan to curb spiralling bank debt at weak state-owned companies could shift growing credit risks away from financial institutions and to the country's private investors, analysts say.

[HONG KONG] China's plan to curb spiralling bank debt at weak state-owned companies could shift growing credit risks away from financial institutions and to the country's private investors, analysts say.

Beijing earlier this month unveiled much-awaited guidelines for a plan to lower the country's US$18 trillion corporate debt - now at 169 per cent of domestic output - by allowing stressed companies to swap part of their debt for equity investment.

So far, two such debt-reduction deals involving indebted state-owned firms have been announced: China Construction Bank Corp (CCB) units will buy debt from some creditors to Yunnan Tin Group Co and Wuhan Iron and Steel Group Corp and swap it for equity in companies of the respective groups.

China's efforts to curb corporate leverage in the system, especially among state-owned companies, are targeted at reviving a slowing economy.

But analysts say the structuring of such transactions pushes the risk to other parts of the economy, specifically the individual investor.

"Overall these transactions can be very large in scale - we are talking about billions if not tens of billions (of dollars) of debt that needs to be renegotiated, revalued and potentially converted into some form of equity," said Wei Hou, senior China analyst at Sanford C Bernstein. "The risk within banks is being shared to a more broader set of capital market."

In the two deals announced so far, CCB, China's second-biggest lender, has listed insurance funds, asset management companies, pension funds, and wealth management products (WMPs) among the sources of funding for taking on corporate debt.

Through the debt-for-equity swap arrangement, lenders can use their off-balance sheet units to buy bank debt owed by the companies targeted by the debt-reducing exercise.

To buy the debt, the units can raise money from private investors through insurance and pension funds as well as WMPs.

Representatives of CCB and Wuhan Iron did not immediately respond to Reuters' request for comment on possible risk for individual investors in debt to equity swaps. Yunnan Tin did not immediately respond to phone calls and a fax sent to its office.

The new rules for swapping debt into equity come after some senior Chinese bankers had resisted the idea of having lenders taking stakes directly in weak firms.

WMPs, much-liked by Chinese savers as they offer potentially high gains, have driven an explosion of shadow-credit in China, now at about 60 per cent of domestic output according to the International Monetary Fund.

Ding Wei, deputy governor of China Merchants Bank, told Reuters at a press conference last week that the bank would be interested in investing some WMP funds into debt-for-equity swaps-related projects, if those investments brought reasonable returns.

In the Yunnan Tin deal, a CCB unit is raising money from various sources including asset management firms, pension funds and qualified individual investors through WMPs to buy 10 billion yuan (S$2.06 billion) of loans, the bank said this month.

The tenure of those investments will be around five years, Zhang Minghe, who leads CCB's debt-to-equity swaps work team said earlier this month.

According to the Beijing-based NSBO Policy Research, the swap includes conditions: If Yunnan Tin fails to meet certain financial targets, it will be forced to buy back the shares at a price to be negotiated later.

The debt-to-equity ratio of Yunnan Tin Co Ltd, a unit of unlisted Yunnan Tin Group Co, was 204.21 per cent at the end of last year, compared to the industry average of 40.14 per cent, according to Thomson Reuters data.

For Wuhan Iron and Steel Co Ltd, a listed unit of Wuhan Iron and Steel Group Corp, it was 161.51 per cent at end December, the data showed.

Analysts say while Beijing has taken steps to rein in shadow-lending, the plan to relieve indebted companies may work against those steps.

"At the end of the day, what (this) does is potentially put more risk back into the system, and systemic risks continues to build up," said Jack Yuan, associate director for financial institutions at Fitch Ratings.