Market-Oriented Debt-for-Equity Swaps

The State Council has recently issued guidelines on market-oriented debt-for-equity swaps and reducing corporate leverage. Chinas financial markets welcome the new documents， whose content takes into consideration the opinions of various market participants as well as experience gained and lessons learned from debt-for-equity swaps conducted in the late 1990s. As long as the guidelines are well implemented in practice， we can be confident of satisfactory results.

The two guidelines most significant stipulation is that corporate leverage reduction and debt-for-equity swaps must be carried out on a market-oriented basis. Within legal frameworks， market participants themselves， lenders in particular， will decide the specific details of debt-for-equity swaps and whether to engage in such transactions， and the government will not force companies， banks and other financial institutions to transact such business. Only in this way can lenders rightsbe genuinely protected.

The documents make clear that the debt-for-equity scheme will not be a “free lunch，” since the government will not absorb concomitant losses as it did during the pilot program in 1999. We must realize that government funds ultimately derive from tax payers， so if the central bank underwrites corporate debt-for-equity swaps， ordinary people will be covertly made worse-off through higher inflation.

The primary intention of the new， market-oriented debt-for-equity swaps arrangement is to protect lenders， and the guidelines clarify responsibility for financial failure by stating that original shareholders must be the first to assume asset losses. Protecting the rights of lenders is a necessary part of social fairness and justice， an essential requirement of a fair market economy， and it will ensure a virtuous circle and development of the economy. This provision is laudable and must be firmly supported.

The guidelines also provide a means to prevent bad debt from merely being rearranged. In the new， market-oriented debtfor-equity swaps， banks may not directly swap non-performing loans for company stakes. Instead， asset management corporations and state investment firms will handle such conversions， in order to better safeguard the rights of banks as lenders.

These stipulations， formed on the basis of lessons learned from past experiences， address the strongest concerns of various market participants.

The two guidelines share a common purpose： lowering companies debt-to-asset ratios while alleviating the pressure for repayment of capital with interest.

As support policies for the two guidelines， the government must also draw up schemes that enable companies to engage in equity financing as soon as possible. Otherwise， after existing loans and other debts are converted to equity， new debt financing will simply expand. The guideline on reducing corporate leverage requires acceleration of the construction of a multi-layer equity market， which will include the development of equity financing and， thereby， promote sound and stable development of stock exchange markets. Launching a registrationbased initial public offering system， however， is the most urgent task.

Debt-for-equity swaps will also provide new investment opportunities for asset management businesses and private equity firms. According to the guidelines， the government will encourage financial， insurance and state-asset management firms to engage in market-oriented debt-for-equity swaps. Furthermore， it will encourage the introduction of private capital， in order to develop mixed ownership， and support cooperation between qualified institutions as well as between such institutions and private equity firms.

Provided the debt-for-equity swaps scheme is well implemented， the measures will benefit Chinas A-share markets in the long term， as listed companies will become much more vigorous and profitable.