Edward S. Steinfeld
Issue:
Cover by Benjamin A. Hurd
China's debt-equity swaps stand at the center of a conceptual debate in China over the nature and role of markets
| Edward S. Steinfeld is assistant professor at the MIT Sloan School of Management and author of Forging Reform in China: The Fate of State-Owned Industry (Cambridge, 1998), focuses on the political economy of industrial and financial restructuring in China. In 1999, he was a visiting scholar at Beijing University's China Center for Economic Research, where he conducted field work for a new project on corporate governance and financial restructuring in China's state-owned industrial sector. |
In a textbook case of adverse selection, poor performers at the enterprise le vel were time and again provided a free lunch, the cost of which is evident in the condition of the contemporary Chinese banking system.
Managers cling to the "market as source of enterprise salvation" view. They implicitly believe that the boundary of the firm is sacred--in effect, that the purpose of reform is to preserve assets as they are currently deployed in the existing firm.
Ultimately, the success of China's debt-equity swaps will not turn on what managers think, regardless of whatever misapprehensions and illusions they may have.
The swap should certainly not be a free lunch for the firm, and it may not even be a last supper. Indeed, depending on the decision of the new owner, it may be an acknowledgement that the borrowing entity has already consumed its last meal, is no longer worthy of financial nourishment, and instead must be dissolved.
The swaps, like many other policy measures, are essentially neutral. Everything depends upon how they are actually applied. Before judging, therefore, we should remind ourselves that Chinese reform ha s been, and will continue to be, a protracted process.
Unlike most state-owned-enterprise (SOE) reform efforts over the past decade, which focused primarily on managerial factors within the enterprise itself, debt-equity swaps target the relationship between firms and banks. In doing so, they constitute an implicit recognition by Chinese policymakers that, at least in the broadest sense, China shares many of the problems of its financially stricken neighbors.
Throughout much of the 1980s and 1990s, Chinese banks served as handmaidens of the state, showering capital upon favored firms at extremely low or even negative real rates of interest. Firms, in turn, operating under chronically soft budget conditions, amassed tremendous liabilities and overinvested in capacity expansion, all the while facing declining real returns on investment. Such enterprise behavior in many respects precipitated China's current bout with deflation. Deflation, in turn, has impinged on enterprise profitability and further tighten ed the screws on heavily indebted firms. While China is insulated from financial panic for a variety of reasons, the country faces many of the same overall ills that plague its neighbors: a financial system dominated by banks; banks with balance sheets awash in nonperforming assets; and major industrial borrowers teetering on the brink of insolvency.
As Chinese commentators have noted, the debt-equity swaps are an immediate policy response to these problems, an effort to kill several birds with one stone. By establishing four asset-management companies (AMCs) to purchase non-performing assets--bad loans--from the four major state banks, the government has created a vehicle, albeit a problematic one, for cleaning up the balance sheets of these banks: the Agricultural Bank of China, Bank of China, China Construction Bank, and Industrial and Commercial Bank of China. As the new holders of outstanding loans extended to SOEs, AMCs convert those nonperforming assets into ownership shares in the borrower firms (see The CBR, November-December 1999). Through their new ownership rights, the AMCs--at least in theory--will be able to substantially restructure and rationalize some of China's largest SOEs. Eventually, the economically destructive and mutually reinforcing pathology of state banks pouring citizens' money into the black hole of state firms will come to an end, or so it is hoped.
Because debt-equity swaps ar e still in their infancy in China (the first swap took place in September 1999, and since then several hundred firms have undergone the process), it is too early to judge their efficacy. However, the swaps are worth examining, for they offer an extraordinary window into contemporary Chinese reform. First, they stand at the center of a conceptual debate in China over the nature and role of markets. Second, they offer an important glimpse into the Chinese policymaking process, particularly the degree to which implementation can have unintended and counterproductive consequences, despite the best intentions of all parties concerned.
The conceptual crossroads
China's debt-equity swaps mark a fundamental crossroads, a conceptual juncture in the evolution of basic societal understandings of the role and function of markets. By the late 1980s, the debate over plan versus market had already become passe in China. Yet widespread acceptance of "market economics" has by no means led to universally accepted notions of what exactly markets are, or how they should function. It is upon this debate, this intellectual evolution, that much of China's economic future turns (see The CBR, January-February 2000).
The "market as source of enterprise salvation" perspective
For much of China's reform era, markets were viewed primarily as incentive mechanisms for enterprises. The notion was that man agerial autonomy, profit retention opportunities, and pressure to show returns on investment--conditions associated with markets--would push managers and entire firms to behave more profitably and efficiently. The vision of markets here is one of all firms responding positively to profit incentives, and all being drawn upward like ships on a rising tide. Markets, particularly with regard to the state industrial sector, were appealing precisely because they would obviate the need for painful restructuring, closures, or unemployment. Instead, they would unleash the latent potential that policymakers believed existed within virtually all state firms, and, in the process, energize the Chinese economy. In this "market as source of enterprise salvation" view, there were to be no losers. When losers did appear, the conclusion drawn almost invariably was that exogenous, non-market factors such as history, inherited burdens within the firm, or policy mistakes were to blame.
In many respects, it is exactly this vision that brought about the problems that debt-equity swaps seek to address, namely high levels of nonperforming loans (NPLs) in state banks and high levels of debt in state firms. Debt-equity swaps are thus a sort of response, 16 years later, to the 1984 policy of shifting SOE financing from direct subsidies to bank loans (bo gai dai). That policy was driven by the idea that if firms were no longer granted subsidies but were instead forced to finance themselves through interest-bearing loans, performance would improve (see The CBR, July-August 1998).
Interestingly, when performance failed to improve--when return on investment actually declined and firms proved unable to repay loans--the conclusion, somehow, was not that market forces were working (as they, indeed, actually were). Few policymakers or enterprise officials would accept the possibility that bo gai dai was doing exactly what it should have done: identify poor performers so that resources could be shifted away accordingly. After all, market forces were not supposed to create losers! Rather than tolerating market outcomes, therefore, decisionmakers backed away from their own policies. When enterprises could not repay the bank loans that had replaced direct subsidies, new loans were simply pumped in year after year.
China's contemporary buildup of NPLs and overindebted SOEs does not indicate the failure of bo gai dai. Quite to the contrary, the buildup indicates the policy's success. For what the policy did--in attaching a nominal price to capital--was to allow us all to see exactly who was failing to show return on investment. The policy makers' perception of failure was simply a reflection of their overestimation of what bo gai dai--and by extention, markets as a whole--could achieve. Operating under these misapprehensions, and facing considerable social and political pressures against shutting down SOEs, policymakers failed to allow market forces to act as selection mechanisms. Instead, in a textbook case of adverse selection, poor performers at the enterprise level were time and again provided a free lunch, the cost of which is evident in the condition of the contemporary Chinese banking system. NPLs accumulated not because of bo gai dai, but because of the mistaken belief that the primary role and function of market forces is to provide salvation to all enterprises.
What is important to recognize is that some of these beliefs are alive and well in China today, a reality confirmed by the current attitude of many enterprise managers toward debt-equity swaps. Theoretically, the last thing a manager in a market economy should want is a debt-equity swap. After all, equity financing is generally more expensive than debt financing over the long run (otherwise, why would an investor purchase equity if he or she could achieve higher returns by simply putting money in the bank?), and the swap itself is an indicator of default. The first thing new equity holders would do--particularly if they were to become majority owners, as in the case of China's debt-equity swaps--would be to consider firing the managers during whose watch so many financial problems accumulated! Under what we normally think of as market conditions, managers run for cover when they hear about debt-equi ty swaps.
In China, though, managers and their patrons in local government for a variety of reasons aggressively lobby for debt-equity swaps. First, they view their high debt--often expressed through liability-to-asset ratios of 80 or 90 percent--as the problem itself, not as a symptom of deeper problems, such as the inability to realize returns on investment. In other words, they do feel they were the losers in bo gai dai, for their firms are now burdened with high debt levels. Second, they do not truly understand that equity financing, like any outside financing, demands returns, lest it migrate elsewhere. Third, they do not seem to believe that new majority equity holders, in this case AMCs, will have the authority, ability, or desire to fire managers or break up the firm.
At a deeper level, managers cling to the "market as source of enterprise salvation" view. They implicitly believe that the boundary of the firm is sacred--in effect, that the purpose of reform is to preserve assets as they are currently deployed in the existing firm. Therefore, they celebrate as a "market victory" the immediate accounting effects of debt-equity swaps. When such swaps occur now in Chinese firms, liability-to-asset ratios are by definition lowered (often from 80 percent to well under 30 percent), and profitability--again by definition--rises. Obviously, if a firm is suddenly relieved of its debt obligations and is not immediately committed to showing returns on equity, its nominal profitability will go up! But how can this renewed profitability be chalked up as a success? After all, nothing has fundamentally changed, save for some accounting issues. The firm's returns on investment remain neglig ible.
It is this fact that the "market as source of enterprise salvation" school has consistently failed to understand. When confronted by failing firms, adherents deny that the failure itself is a product of market forces, but instead seek a variety of "market" remedies--debt-equity swaps, new infusions of capital, and initial public offerings (IPOs), just to name a few. All the while, they operate under the illusion that they are providing some sort of last supper, some sort of last infusion of capital before market strictures are really applied, or more accurately, before the firm realizes the unleashing of its true market potential.
The unfortunate reality is that many of these firms have no market potential, and as such, will never take off if exposed to market forces. Time and again, policymakers and managers alike may persuade themselves that each new infusion of capital is a last supper, but what everybody knows--or at least what many managers have come to believe--is that each last supper has been, and will always be, a free lunch. For an SOE manager in China today, the debt-equity swap program is no different.
The "market as selection mechanism" perspective
Ultimately, the success of China's debt-equity swaps will not turn on what managers think, regardless of whatever misapprehensions and illusions they may have. Instead, success will turn on the savvy, ability, and aut hority of both the policymakers administering the swaps and the AMCs participating in them. As noted above, the swaps are coming at a time of considerable intellectual ferment on the economic front in China. Reflecting this ferment, the swaps, much like China's dramatically evolving stance toward World Trade Organization (WTO) membership, mark an extremely important conceptual waypoint in the reform process.
Unlike many of their counterparts in the enterprise sector, the conceptual originators of China's debt-equity swaps harbor few illusions regarding the "market as salvation" view. They understand perfectly well that markets, rather than saving all firms, create losers just as much as winners, and that only through the winnowing of losers from winners can growth and efficiency be achieved.
The basic idea is that markets are little more than selection mechanisms using the vehicle of price. By attaching prices to inputs--whether physical or financial--and by allowing those prices to respond to the pressures of supply and demand--markets broadcast signals regarding the effectiveness with which resources are being utilized. When those who utilize resources show high returns, those who have additional resources pump in more investment accordingly. When users of resources show low returns, holders of additional resources invest elsewhere. The "market as selection" view asserts that only through this process of selection, of letting winners win and losers lose, can China realize the incentive effects so sought after by the "market as source of salvation" school. Markets cannot and must not avoid losers, for only by tolerating losses and the resulting reallocation of resources can effective incentives for the efficient utilization of resources be achieved. In this view, the goal is not to save existing firms, whether state owned or private, but instead to allow firms to rise and fall so that efficient outcomes and growth can be achieved for the system as a whole. Basically, the objective is to improve the system, not save the individual firm.
The debt-equity swap, from this perspective, becomes a vehicle not to save firms, but rather to apply market-selection mechanisms, often at the expense of distressed firms. For the originators of the program, debt-equity swaps are not at all a means of relieving firms from onerous debt burdens to achieve instant nominal profitability. Indeed, mountains of enterprise debt are viewed not as a disease per se, but instead as a mere symptom of far deeper problems. The idea, therefore, is not simply to pick the "best" firms for debt-equity swaps, relieve them of interest payment burdens, and then allow them to go off on their merry, and profitable, way. Rather, the notion is that only the worst, most unredeemable firms should be selected, and selected because new equity owners will be able to come in and either radically restructure the defaulting firm or utterly dissolve it. The swap becomes the lead-in to market selection, not enterprise rejuvenation. In short, the swap makes sense only in the context of strategic downsizing of the SOE sector.
Even from the micro perspective, a lender, when confronted by a defaulting borrower, reasonably pursues a debt-equity swap only as a worst-case option short of bankruptcy proceedings (in which case the lender stands little, if any, chance of recovering funds). If the borrower is essentially healthy, but for whatever reason cannot meet the terms of a loan in a given period, the lender would be much more inclined to pursue a variety of measures short of actually coming in and trying to take an ownership stake in the borrower. The terms of a loan can be renegotiated and extended, and in more extreme cases the lender can push for restructuring commitments or managerial changes.
The debt-equity swap, however, is an extreme measure, an acknowledgement that the borrower suffers from intrinsic governance problems that cannot be resolved through renegotiated terms. For those problems to be resolved, the new owner--a bank or other financial intermediary--has to have full ownership rights, including the authority to appoint managers, transfer ownership to other parties, or totally liquidate the assets of the firm. Basically, debt-equity swaps make sense only in the context of markets as selection mechanisms, and they make sense only for the worst firms. The swap should certainly not be a free lunch for the firm, and it may not even be a last supper. Indeed, depending on the decision of the new owner, it may be an acknowledgement that the borrowing entity has already consumed its last meal, is no longer worthy of financial nourishment, and instead must be dissolved. Only to the extent that this extreme option becomes credible can the owner hope to achieve some returns, either through the restructuring or liquidation of the firm.
Prospects for the future
What should be clear from this discussion is that though debt-equity swaps are proceeding in China, they are proceeding in an environment of markedly divergent expectations. On one side are those who believe, as they have for two decades, that the core of the SOE sector is basically sound, but that some state firms need to be revived through yet another round of debt relief--in this case, debt-equity swaps. On the other side are those who believe that an entirely new page must be turned in the reform process, that fundamental strategic downsizing must occur in the state industrial sector, and that debt-equity swaps are but the first step in this radical downsizing process.
In terms of China's long-term growth, the stakes in this debate are undoubtedly high. Should the first school of thought trium ph, we can expect a reaccumulation of NPLs in the banking system, and persistent problems of insolvency and low return on investment in the SOE sector. Ultimately, these all point toward slower economic growth in the future.
Alternatively, should the second school prevail, we can hope to witness the deepening of reform and restructuring in core portions of the economy. While none of this need happen overnight, it does need to happen ultimately--at whatever pace--so that China can continue to achieve the growth it both expects and desires. Debt-equity swaps will not solve all of China's problems, but depending on how they are ultimately managed, they can serve as important signals to economic actors throughout the system.
That said, many issues surrounding the swaps are being resolved ad hoc through the implementation process. While nobody knows exactly how these will ultimately play out, some decidedly ominous signs hav e already emerged.
AMCs, as a matter of policy, have been required to purchase bank NPLs at full face value. Virtually nobody either inside or outside China, however, believes that the true value of these assets is anywhere close to par. To pay for assets at par, AMCs have little choice but to issue bonds to the sellers of the assets, state banks. Yet how can those bonds ultimately be serviced if the real value of the assets--formerly loans to enterprises, and now equity in enterprises--is so low? What sort of exit option do the AMCs realistically have under these terms? Who, eventually, is going to absorb the difference between the par value of these assets and their real market value? Two outcomes, neither particularly desirable, might occur. In one, banks and AMCs may try to keep enterprises afloat in the somewhat dubious hope that enterprise assets may climb in value. The outcome suggests lots of continued bank loans to firms. In the second outcome, AMCs exit quickly, but default on their bond commitments to the banks. In that case, the very banks whose NPLs were relieved by debt-equity swaps will see distressed assets appear once again on their own balance sheets.
The State Economic and Trade Commission (SETC), formally in charge of supervising debt-equity swaps, must provide initial appr
oval for any firm seeking to participate in a swap. SETC, unfortunately, has stipulated conditions that qualify only the "best" firms for swaps: firms with "exceptional" management teams, advanced technologies, competitive products, and so on. If these firms are so exceptional, they should have simply renegotiated the terms of their outstanding loans with the banks rather than undergoing debt-equity swaps. If these firms are in reality not so exceptional, they have just been anointed with a mark of approval from the state, making it all the more difficult for new equity holders to fire managers, sell off assets, or otherwise restructure the enterprise. SETC's stipulations, no matter how well-intentioned, in effect undercut the power of new enterprise owners, the AMCs. In a broader sense, SETC's stipulations run counter to the notions of strategic downsizing and "market as selection mechanism."
Related to the problematic role of SETC is Premier Zhu Rongji's three-year commitment to "resolve the difficulties" (jie kun) of large SOEs, a promise that will come due in 2001. SETC, charged with the task of meeting this commitment, faces pressure to use debt-equity swaps to achieve short-term financial results in SOEs. In other words, as long as nobody clearly defines what jie kun really means, the inclination on the part of managers and officials alike is to seek qui
ck ways to improve enterprise profitability. As noted above, debt-equity swaps, which instantaneously relieve enterprise interest payment burdens, by definition pump up the short-term profitability of firms. Yet, these improved profit figures reflect accounting changes rather than any resolution of the intrinsic problems that were causing low returns on investment and the buildup of unserviced debt. The basic reality remains unchanged. Regardless of how their accounts are juggled, these firms remain unable to show acceptable returns on investment. The potential result of the Premier's promise--whether intentional or not--is that the debt-equity-swap program will be transformed from a novel restructuring measure into a more traditional subsidization policy for commercially unsustainable firms.While none of these factors bode particularly well, it is still far too early to judge China's debt-equity swaps. The swaps, like many other policy measures, are essentially neutral. Everything depends upon how they are actually applied. Before judging, therefore, we should remind ourselves that Chinese reform has been, and will continue to be, a protracted process. Over the years, two steps forward have almost always been matched by one step backward. There is no reason to expect otherwise today.
What is new, however, is the recognition system-wide that significant problems have accumulated throughout the reform proc ess, problems that are manifested in the weak condition of the Chinese banking and heavy industrial sectors. The debt-equity swap program, like China's bold attempt to enter the WTO, is at least in part an indicator of novel thinking on the reform front. In this sense, debt-equity swaps, like WTO accession, truly stand at a conceptual, and potentially extremely productive, crossroads. Yet, just as important, these policies--emerging in an environment of mixed ambitions and expectations--are still now essentially up for grabs. China may have years ago opted for "the market," but the time has come for key actors within the system to determine exactly what kind of market they have opted for.
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China's Economy, First Quarter 2000 While it is still too early to proclaim a full economic recovery, China's first-quarter economic performance improved significantly over the same period last year. The pickup is due largely to strong export growth, increased consumer spending, and the ongoing government stimulus program. GDP China's GDP rose 8.1 percent in the first quarter of 2000 over the same period last year. As much of the growth is due to rising exports, analysts forecast a healthier economy through the res t of the year. The State Development Planning Commission's Economic Research Institute, for instance, is predicting a year-end GDP growth rate of 7.5 percent, up from 7.1 for 1999. Investment Government spending continued to drive the rise in investment. State-sector fixed-asset investment rose 8.5 percent year on year, fueled largely by a RMB60 billion ($7.3 billion) Treasury-bond issue in late 1999. This year, China plans to issue RMB100 billion ($12.1 billion) in long-term T-bonds. While some of the money will go toward infrastructure investment, Finance Minister Xiang Huaicheng has said that a good portion of it will be used to mobilize private-sector investment. As much as 70 percent of China's new fixed-asset investment, bond financing, and government grants will go to developing western China. More funding is also expected to be earmarked for environmental protection programs, technical upgrades in enterprises, and China's woefully inadequate social security system. Utilized foreign direct investment (FDI), though down for the quarter overall, rose 10.3 percent in March from February, breaking a long downward slide. Contracted investment was up by 27 percent for the quarter. China's pending World Trade Organization (WTO) entry may have encouraged investors, and the country's progress toward entry could spur further recovery in FDI in coming months. Output U p 10.7 percent, value-added industrial output rose more than expected in the first quarter, boosted largely by government spending and strong export demand, but also by a slight improvement in domestic demand. Heavy industry grew 11.5 percent, while light industry grew more slowly. Telecommunications and service output rose rapidly--mobile phone output jumped an eye-popping 140 percent, according to the State Statistical Bureau (SSB). Consumption The rise in consumer spending may be due to the trickle-down effect of strong exports. If that is the case, consumer demand may strengthen--as long as external demand stays strong. Rising consumption, in turn, could help deplete stockpiles and boost price levels. On the other hand, the first-quarter increase in consumption may have been chiefly a result of the burst of spending that accompanied the extended Chinese New Year holiday, in which case it could be temporary. The extension of the May Day holiday to one full week may similarly help second-quarter figures. Nevertheless, while fears of job losses and ongoing reforms have prevented a full recovery of consumer confidence, SSB reports that its Consumer Expectation Index is at its highest level since August 1998, and that retail sales were up 10.4 percent from the same period last year. Moreover, the State Internal Trade Bureau predicts that first-half consumer spending growth will reach 8.8 per cent, and that retail sales will rise 7.7 percent in the second quarter. Prices Deflation persists despite the rise in consumer spending. After turning positive in February for the first time in more than two years, the consumer price index fell into negative territory again in March and April. Most analysts agree that deflation is gradually bottoming out, but that much depends on domestic consumer confidence. Non-state sector Over the last year, China has taken several steps to boost the non-state sector. Last spring, it was upgraded to an "important component" of the economy in the constitution, and a new law on single-investor enterprises (SIEs) went into effect in January. The SIE law allows individuals to set up enterprises with few restrictions, though the investor is subject to unlimited liability for the debts of the enterprise. A new law for small and medium-sized enterprises is also reportedly in the works. A recent International Finance Corp. (IFC) report has suggested that China's non-state sector may be larger than previously thought. The private sector accounted for a third of China's GDP in 1998, the report found, compared with 37 percent from the state sector. The IFC reportedly included shareholding companies, foreign and domestic private enterprises, and about half of the so-called collectives in its definition of the private sector. Financial sector reform China has recently been floating ideas for financial reform in an effort to prepare the sector for WTO entry. Once China accedes, foreign banks will be able to serve Chinese firms within two years, and offer retail services in five years. Beijing may soon allow domestic banks to list on the domestic market.
--Virginia A. Hulme Virginia A. Hulme is assistant editor of The CBR.< br>
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