Chinese debt-to-equity swap program

China’s central bank recently cut the required reserve ratio (RRR), with a significant portion of the released liquidity aimed at supporting the debt-to-equity swap program. As a major deleveraging measure in the corporate sector, particularly for SOEs, the current debt-to-equity swap program began in late 2016. Compared to the last program rolled out in the late 1990s, which was criticized for heavy government intervention, the current program is more market-oriented. However, progress this round has been slow. Nevertheless, we expect the program to accelerate in the coming months given the government’s ongoing determination to deleverage.

As China’s central government focuses on financial stability, a top priority is deleveraging in the corporate sector, particularly for SOEs. A key measure to achieve this “structural deleveraging” will be the debt-to-equity swap program, which the government initiated in late 2016 along with the supply-side reform and the new round of SOE reform. Notably, the PBOC recently cut the reserve requirement ratio (RRR), with a significant portion of the released liquidity aimed at supporting the debt-to-equity swap program.

While China’s last debt-to-equity swap program in the 1990s involved heavy government intervention, including the provision of funding sources and the selection of targeted firms, the current program is more market-based, particularly in terms of funding sources, and dominated by banks. However, we believe these market features may also explain the program’s slow progress thus far, given its negative effect on capital in the banking sector and the lack of low-cost funding sources.

We expect the debt-to-equity swap program to accelerate in the coming months for two key reasons. First, the program could be the most effective way for the government to achieve its policy goal of keeping macro leverage under control over the coming three years. Second, the recent rise in corporate defaults could also be a catalyst for the government to push the implementation of the program. Indeed, policy makers appear to be taking steps to mitigate the potential for rising default risks, with measures including recent RRR cuts. Looking ahead, we forecast one RRR cut per quarter in H2 as the government moves to offset downside risks to growth and drives structural deleveraging through the debt-to-equity swap program.