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Deleveraging and Role of Debt for Equity Swap
YIN Jianfeng
National Institute for Finance & Development (NIFD)
University of International Business & Economics
Deleveraging
tops the agenda of China’s current priorities to “reduce leverage, overcapacity
and inventory, lower cost and make up for weak spots”. However, as can be found
through comparison with other countries, China’s leverage ratio is only at a
medium level and far below the level of countries like Japan and Spain that are
struggling with economic woes. For BRICS countries with leverage ratios below
China’s, such as Brazil and Russia, their economies seem to underperform
China’s. While excessive average is to be avoided, it is not the case that the
lower leverage ratio, the better.
Further
comparison of China, the U.S. and South Korea with similar leverage ratios
reveals that despite the high leverage ratio in its non-financial corporate sector,
China’s leverage ratios in household and government sectors are far below the
levels of the U.S. and South Korea. Majority of liabilities in China’s
non-financial corporate sector are SOE liabilities. After deleveraging for SOEs
through debt for equity swap in 2000, the share of SOE liabilities in the
non-financial sector kept on the decline but is so far still above 50%. After
the deduction of household and government liabilities, however, SOEs account
for more than 70% of liabilities in non-financial corporate sector. China’s
rising leverage ratio after the hefty “four trillion yuan” stimulus package in
2009 is essentially an accumulation of SOE liabilities. That is to say, if
deleveraging is China’s current top priority, the key to deleveraging is to
reduce the leverage of SOEs.
Notably, the
asset-liability ratio of SOEs indeed reached record highs. Since 2009, the
aggregate asset-liability ratio of SOEs has been rising rapidly, reaching 67%
in the first half of this year, which is above the level of 2000. Among all
SOEs, central SOEs have been increasing leverage at a much faster pace.
Compared with 2008, the asset-liability ratio of central SOEs rose by eight
percentage points, reaching the record highs of 68%. Since 2011, the
asset-liability ratio and indebtedness of central SOEs exceeded that of local
SOEs: in the first half of this year, the liabilities of central and local SOEs
amounted to RMB 45 trillion and RMB 38 trillion respectively.
For a company,
if return on assets is higher than loan interest rate, shareholder interest
will be best served by raising asset-liability rate. For an economy, if
aggregate demand, capital deepening and economic growth can be spurred by
investment with borrowed money, the supply side of the economy as a whole will
also improve. In this case, leverage ratio for the economy should be increased.
However, the
assets of SOEs are deteriorating. Return on SOE assets has been on the decline
since 2008 and reached less than 1% in June 2016, the lowest ever since 1997
and far below the current benchmark one-year interest rate of 4.35% and even
below the overnight lending rate of around 2%. In parallel to falling return on
assets, SOE liabilities and assets kept on the increase, up over 15% in 2015.
With falling
return on assets and stymied growth of primary operating revenue, SOE
liabilities and asset expansion inevitably led to the “advancement of state
sector and retreat of private sector.” At the onset of global financial crisis,
the growth of household consumption, private enterprise investment and external
demand fell sharply, while SOE investment compensated for aggregate demand, as
reflected in the rapidly growing number of SOEs. According to the statistics of
the Ministry of Finance, during 1997-2009, the number of central and local SOEs
dropped from 250,000 to 110,000. After 2010, the number of SOEs began to
increase. In 2014, it grew by 50,000 over 2010, reaching 160,000. Meanwhile,
the overall efficiency of SOEs is significantly below the level of non-SOEs.
Take industrial enterprises for instance, return on assets for large industrial
enterprises averaged 7.7% during 2006-2014, while this figure only stood at
3.9% for SOEs. Although SOE expansion compensated for aggregate demand and
stabilized the economy, the inefficiency of SOE assets compromised the
supply-side efficiency of the economy as a whole.
In 2014,
liabilities in seven sectors from industrial sector to wholesale, retail and
catering sectors accounted for 96% of total SOE liabilities. Of which,
government-affiliated organizations, social services, real estate, construction
and transport and warehousing sectors experienced rising liabilities over 2008.
SOE expansion since 2008 at least has the following problems: first, such an
expansion is inconsistent with the long-term priorities of SOEs. According to
the decisions adopted at the Third Plenary Session of the 18th CPC
Central Committee, the “functions of various types of SOEs must be accurately
defined”, so that state capital investment on public-interest enterprises will
be increased and competitive sectors will be deregulated. Second, such an expansion
is inefficient given the industrial structure. Return on assets is low or very
low for the five sectors with rising shares of liability in 2008. On the
contrary, the share of liabilities barely budged and even declined for strategic
sectors with higher return on assets, including scientific research and
technology services, IT services, education, culture and broadcasting.
Liabilities can
be reduced either on liability side through debt for equity swap and
eliminating zombie firms or on asset side through the improvement of corporate
governance and introduction of new technology that contribute to higher return
on assets. As mentioned before, enterprises must reduce leverage due to problems
on asset side, so the solution must rest with asset side. Increasing return on
corporate assets will contribute to TFP and potential growth rate and resolve
the problem of long-term economic sustainability on supply side.
As can be
learned from Japan’s lessons, deleveraging on liability side without addressing
asset side will lead to stagnation without lowering the leverage ratio of
economy. Hence, deleveraging on liability side must be combined with increasing
return on assets. Such combination can be made through the following methods:
first, optimizing the structure of enterprises and sectors with liabilities by
increasing the liabilities of more profitable businesses and sectors and
reducing those with little prospect of improving return. Here, let us focus on
the issue of debt for equity swap.
Though it
reduced the burden of SOEs, the debt for equity swap in 2000 did not
fundamentally resolve the problem of inefficiency for SOE assets. As a matter
of fact, improvement in SOE performance after debt for equity swap in 2000
largely benefited from China’s entry into the WTO in 2002 in a rising cycle of
global economy. Now that 8 years have elapsed since the onset of global
financial crisis, the world economy shows no sign of recovery from recession.
In such a context, it is unrealistic to resolve the asset inefficiency and
supply-side structural problems of enterprises by repeating the debt for equity
swap in 2000.
We must have a
correct understanding on what debt for equity swap is: (1) from liability side,
debt for equity swap is indeed a means to supplement capital and reduce
leverage; (2) from asset side, debt for equity swap is the fundamental means to
improve shareholder and governance structures; (3) from an overall perspective,
debt for equity swap is a means to define SOE functions and “give play to the
decisive role of market and proper role of government.” In planning to conduct
debt for equity swap, enterprises and government departments overlooked the
second and third aspects.
We must also have a clear idea about what
debt for equity swap is not: (1) debt for equity swap is not a means to lower
financing cost and burden for businesses. Equity should be held by economic
entities other than banks and their subsidiaries. Otherwise, liabilities will
still be in the same hands, though in another form. Nevertheless, return on
equity is higher than return on liabilities; (2) debt for equity swap is not a
means to enhance the capacity of banks to clear and recover liabilities. After
debt for equity swap, banks will relinquish the right of mortgage and rank the
last in the sequence of a company’s bankruptcy liquidation. Hence, banks cannot
conduct debt for equity swap just to resolve the solvency difficulties of
enterprises; (3) debt for equity swap is not a means to reduce overall leverage
ratio. Instead, it should be targeted at sectors and enterprises with good
technology prospects. These sectors and enterprises account for a limited share
of SOE liabilities and as mentioned in the first point, if equity cannot be
held by others market players, overall leverage ratio will not reduce after
consolidation.
In line
with the spirit of the Third Plenary Session of the 18th CPC Central
Committee for supply-side structural reforms, we must strive to improve
corporate asset side and macroeconomic supply side through debt for equity swap
while improving corporate financing structure on liability side. We must also
improve China’s basic economic system encompassing property rights protection
system, mixed ownership system, modern corporate system for SOEs and
development of non-public economy.