In December 2015, when supply-side reform was introduced at the Central Economic Work Conference, the Chinese government proposed “deleveraging” for the first time, initiating an active deleveraging process to restructure its economy for better investment returns. Now, adjusting the composition of leverage ratios in non-financial sectors has become the top priority for the deleveraging campaign. In April 2018, the Central Finance and Economics Committee proposed structural deleveraging at its first meeting, establishing varied requirements both for sectors and for categories of debts, asking local governments and enterprises, especially state-owned enterprises, to lower their leverage ratios as soon as possible. On 2 July 2018, the newly elected Financial Stability and Development Committee of the State Council also said that “structural deleveraging would be made the fundamental strategy [for preventing and defusing financial risks]”, signalling more precise deleveraging measures in the future.
In one of the modest measures related to deleveraging, the government has been encouraging the use of equity plus debt schemes and debt/equity swaps (DESs) as financing/refinancing solutions. With regards to DESs, the State Council released the Opinions on Actively and Steadily Lowering the Leverage Ratio of Enterprises and the Guidelines on Market-Oriented Debt/Equity Swaps of Banks (No.54 Guidelines) in October 2016, which (1) require banks to implement market-oriented DESs in an orderly manner with the aim of actively helping enterprises to reduce their leverages steadily; (2) allow banks, implementors and enterprises to agree on the debts and equities to be converted, as well as the prices, terms and conditions of conversion on their own, provided that such agreements conform to state policies; and (3) allow implementors to raise funds for DESs using market-oriented approaches, thus enabling the market-oriented exit of equity holders through the use of multiple approaches or channels. In January 2018, the National Development and Reform Commission (NDRC), the People’s Bank of China (PBOC) and five other ministries and commissions jointly issued the Circular on Specific Policy Issues Concerning the Implementation of Market-oriented Debt/Equity Swaps by Banks (Circular). In June 2018, the China Banking and Insurance Regulatory Commission issued the Measures for the Administration of Financial Asset Investment Companies (Trial) (Measures).
The No.54 Guidelines, the Circular and the Measures mentioned above, which set forth fundamental principles and implementation approaches for market-oriented DESs under the rule of law, pave the way for a new wave of such exercises.
The new DESs are different from those of the late 1990s, especially in terms of implementation approach and environment. The latter were policy oriented, with debt-to-equity enterprises, debts to be converted and implementors involved mostly determined by the government, including capital mainly raised by the government from diverse sources. On the contrary, being the results of market-oriented developments and the rule of law, the upcoming DESs will roll out without governmental intervention. Instead of being fixed by the government, the debts to be converted, the conversion prices, and the implementors carrying out transactions will be determined by market players at their discretion through consultations, with capital for the transactions to be raised mainly through market-oriented approaches. Market players will make their own decisions, reaping profits and taking risks on their own. The government’s main responsibility is to provide policy support and guidance, while acting as a regulator and supervisor.
As for the implementation environment, compared with those of the late 1990s, the new DESs will benefit from improved systems and mechanisms, as well as strengthened rule of law. Most importantly, it will benefit from well-established regulations, much diversified ownership structures and, especially, a more developed capital market, in addition to improved governance structures of market players, including enterprises, banks and implementors. In all, the conditions necessary for implementing market-oriented DESs in a manner that respects the rule of law are in place.
We will also see a broadening of the base of DESs implementors. Apart from the four asset-management companies already taking part in the late 1990s, a range of entities will join DESs as implementors. They include local asset management companies (AMCs), financial AMCs established by commercial banks in accordance with the Measures, as well as insurance asset-management institutions and state-owned capital investment and operation companies.
In terms of enterprises as debtors, as specifically stated in the Circular, all such entities, regardless of the nature of their ownership structure, and including various non-state-owned enterprises, are allowed to carry out market-oriented DESs. However, a white list and a negative list have been established to encourage enterprises with strong prospects, albeit experiencing some temporary headwinds to carry out market-oriented DESs, while there are also explicit provisions prohibiting zombie companies, untrustworthy companies and companies that do not comply with state industry policies from carrying out these transactions.
As for the range of claims that may be converted into equities via DESs, according to the Circular, in addition to claims held by banks, there are other types of creditors’ rights permitted to be converted into equities through market-oriented DESs. Specifically, the scope of permitted claims, involving mostly bank claims arising from loans to enterprises, is established with appropriate consideration for other categories of claims, including claims arising from lending by finance companies, entrusted loans, loans relating to finance leases, and working capital loans. Claims resulting from private lending are expressly excluded. However, as a principle, claims or debts that bank-affiliated implementors are allowed to purchase or repay by using market-oriented DESs are restricted only to bank loans, while appropriate consideration is given to other categories of claims held by banks and non-bank financial institutions.
With regard to the code of practice for matters related to DESs, the Measures state that, when acquiring any claims from banks, financial asset investment companies must ensure that the transfer is clean and authentic. Also, this rule shall apply to other implementors with necessary alterations.
To ease the funding pressure of DESs, the NDRC issued Guidelines for Issuance of Bonds for Market-oriented Debt/Equity Swap Programs of Banks in December 2016. The PBOC also announced a targeted RRR cut in June 2018 to encourage banks to carry out DESs programs priced through market-oriented methods, using liquidity released from the RRR cut and capital raised from the market.
Wu Jiejiang is a partner at Jingtian & Gongcheng