Debt-to-Equity Swaps Are Only Feasible for Healthy Firms, IMF's Deputy Zhu Says
Yicai Global
/SOURCE : Yicai
Debt-to-Equity Swaps Are Only Feasible for Healthy Firms, IMF's Deputy Zhu Says

(CBN Global) April 19 -- Debt-to-equity swaps are only feasible for those companies with relatively healthy debts, otherwise it could simply be a transfer of risk to the financial system, according to Mr. Zhu Min, deputy managing director of the International Monetary Fund.

Economic pressures have meant that the good credit rating of state-owned enterprises has been eroded. China Railway Materials Commercial Corp. recently became the first state-owned enterprise to have its corporate bonds suspended. Hence, debt-to-equity swaps seem to be a sound strategy to buffer against bad debts.

Although China has made some progress in rebalancing its economy, the profitability of Chinese companies has continued to slump over the past five years, as corporate debts hang over them. In Mr. Zhu's opinion, debt-to-equity swaps will only resolve part of the issue, and other measures such as corporate debt restructuring and bankruptcy reorganization should also be used.

Due to increased debts and declining profitability, Chinese firms face an increasing challenge to make debt repayments, according to the IMF. Presently, the debt/EBITDA (earnings before interest, taxes, depreciation and amortization) ratio for Chinese companies is at a median of four, double that of 2010. The proportion of potential bad debts, or not generating sufficient earnings to pay interest rates, now accounts for 14 percent of total debt, while the average proportion from 2010 to 2015 was only four percent.

Real estate is also crucial to China's deleveraging process and the question remains of whether should China stabilize the housing market as it stabilized the stock market.

"Without the destocking of inventories, property developers are unlikely to keep investing. Therefore, destocking is necessary to boost economic growth," Mr. Zhu said.

In Mr. Zhu's opinion, the Chinese property market still faces two critical issues, namely excessively high inventories and excessively high prices.

China's housing inventory has now reached one billion square meters and will require between four to five years to be fully cleared, according to an IMF estimate made a year and a half ago.

Yet this is not a simple process. "Property investment accounts for 20 to 25 percent of the country's total investment which was growing consistently at about 30 percent. That growth has now decelerated to zero, making it an important contributor to China's economic slowdown. We estimate it will cut Chinese GDP growth by 1.5 percent."

Mr. Zhu, who provides policy advice to the US government, has long maintained close communications with the United States Treasury Department and the Federal Reserve. The IMF has consistently recommended the Fed remain cautious about interest rate hikes and focus on data, as the global financial market becomes increasingly interconnected. There are not only 'spill-overs' from the US to non-US countries but also 'spill-back' from non-US countries to the U.S.

Price stability (inflation) and employment are two major indicators of US economic fundamentals. The US still has a long way to go before reaching its two percent inflation target. "For inflation, PPI is actually an important measure to look at. Some 80 percent of the economies worldwide have a negative PPI. Prices of tradable products have fallen substantially, pointing to weak global demand and increasing competition," said Mr. Zhu.

In addition, the US labor market is not doing as well as indexes have suggested, despite the unemployment rate falling to a post-financial-crisis low of five percent. "One difficulty in making assessments lies in the fact that the unemployment rate is based on surveys rather than statistics. Second, the labor participation rate has fallen by three percentage points. Should the three percentage points be translated into unemployment rate? There has been a huge controversy both within the Fed and among major institutions, each having numerous models doing the computations."

The US has been subject to overseas market volatility to an unprecedented degree. "Any fluctuations in emerging markets have a global impact to which the US is not immune. Additionally, although China does not have a substantial direct effect on the US financial market, China's economic trends directly affect US market confidence," said Mr. Zhu.

"The US financial markets have undergone structural changes, with the financing function of banks gradually shifting to shadow banks, such as asset management companies. One of their important features is global allocation of funds. The term shadow banks no longer refers to money market funds as it did in 2007," said Mr. Zhu.

"The world's big five funds account for a significant portion of emerging market equity investments. US-based assetmanagement companies have expanded their overseas investments in emerging markets such as Indonesia and Malaysia to between 30 and 40 percent from five percent a decade ago," Mr. Zhu pointed out.

All these signs support one view, which the IMF has insisted on, that the Fed should remain cautious about hiking interest rates as overseas trade and financial transactions have big impacts on the US economy.

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