Wang Guogang: Options for Deleveraging
Created On : 2017-12-06    Views : 265

Source: China Securities Journal

The debt structure of a real enterprise is mainly determined by its financial structure. So, a real enterprise must adjust its financial structure and improve the proportion of direct financing to optimize the debt structure. Combining equity with debts through the banking system, such as the investment and loan linkage and market-based debt-to-equity swap, involves many risks and is just one possible way for a real enterprise to lower the leverage ratio. From the perspective of giving play to the role of the capital market, other options include stepping up the efforts to issue medium and long-term corporate bonds and preferred stocks, restricting the transfer of funds to financial operation by non-financial listed companies, and the concentrated reduction of shares for cash by the shareholders of listed companies, encouraging equity investment institutions to increase equity investment in real enterprises, and further expanding the financing function of the stock market.

The Investment and Loan Linkage and Market-based debt-to-equity swap Involve Certain Risks

As for “improving the financial market system”, the outline of the 13th Five-Year Plan highlights efforts to “vigorously develop a capital market that is open, transparent, and healthy, increase the proportion of direct financing, and lower leverage ratios”, and to “steadily advance innovation in bond products and promote financing methodology that combines high-yield bonds with equity and debts”. Since 2016, the State Council and relevant authorities have successively launched new moves that combine equity with debts to help real enterprises lower leverage ratios. At present, preparation for the investment and loan linkage and market-based debt-to-equity swap is underway, with the purpose of creating more favorable conditions for implementation.

The investment and loan linkage and market-based debt-to-equity swap are characterized by three aspects. First, both operations are conducted by pilot commercial banks and have no relations with the financial system restructuring dominated by indirect finance. In investment and loan linkage, pilot commercial banks expand their scope of business from deposits and loans to investment operation; in market-based debt-to-equity swap, pilot commercial banks can change loan assets into equity assets. Both operations help the commercial banks expand their business into investment without revising relevant provisions prescribed in the Law on Commercial Banks. Second, both operations have the precondition that the pilot commercial banks set up subsidiaries. In investment and loan linkage, pilot commercial banks can set up subsidiaries that are engaged in direct investment and exercise the function of direct investment independently; in market-based debt-to-equity swap, pilot commercial banks can set up solely-funded asset management companies for the transfer of credit assets into equity. That results in a business mechanism characterized by mother-child relationship between the pilot commercial banks and their subsidiaries. Third, to the pilot commercial banks, the operations are also intended for the market exit of equity. So, besides expanding into investment operation, they also expect the returns on equity investment to be higher than those from interest.

The investment and loan linkage and market-based debt-to-equity swap involve risks in five aspects.

i) Credit risk: According to the provisions about the capital adequacy ratio, the assets that a commercial bank uses for direct investment (thus becoming equity) can’t be included into capital. So, the amount of funds that the pilot commercial bank uses to set up direct investment companies and asset management companies must be deducted from the capital adequacy ratio of credit assets. If we assume the capital adequacy ratio is 10% and the registered capital for setting up a direct investment company is RMB 10 billion, that means the credit capacity of the pilot commercial bank will be reduced by RMB 100 billion. In the investment and loan linkage and market-based debt-to-equity swap, the pilot commercial banks may set up around 15 direct investment companies and asset management companies. So, the reduced credit capacity may be above RMB 1 trillion. If the pilot commercial banks want to expand into investment while maintaining the growth of credit capacity, they must increase capital funds through increasing capital and shares, which however will give rise to new risks.

ii) Moral risk: The investment market is a perfectly competitive market with tens of thousands of investment institutions. Under the background of asset shortage, many investment institutions are seeking targets that are most suitable for their investment orientation and price intentions. Although the loans from the pilot commercial banks may give them some advantages, direct investment companies may use up the limited resources in years as equity investment is a long-term business in which there are many investment options and competitors; besides, it’s hard for the direct investment companies to tell whether the projects they invest in are quality ones with bright prospects. As the direct investment companies are stuck in a dilemma, the commercial banks as their parent companies are likely to give a helping hand. Since the help is there sooner or later, direct investment companies may be bold in investment operation. But as a result, the parent companies may take all the bad consequences of the investment. That is also possible in the market-based debt-to-equity swap.

iii) Maternal love risk: The market mechanism highlights the principle of openness and fairness, but the equity ties between the pilot commercial banks and their subsidiaries hinder the implementation of the principle on some important occasions. For example, when an asset management subsidiary encounters difficulties in operation, the parent bank, for the sake of performance, may degrade the credit assets with higher quality (such as degrading the rating from “substandard” to “doubtful”) for the subsidiary to carry out debt-to-equity swap. That not only shows the support from the parent company, but also provides favorable conditions for the negotiation about debt-to-equity prices. In investment and loan linkage, parent companies can also show their support for subsidiaries through credit arrangements (including credit amounts, terms, facility and interest rates). But the fairness and openness of the market mechanism will be challenged on such occasions.

iv) Connected transaction risk: After a direct investment company invests in a technological innovation enterprise, the parent commercial bank may grant loans to the invested technological innovation enterprise. That results in the connected transaction between the loan of the commercial bank and the investment of the subsidiary. Despite the provision that a direct investment company “can’t use debt funds, funds it manages as an agent, funds it is entrusted to manage and non-self-owned funds in any other forms” to invest in technological innovation enterprises, connected transactions resulted from the arrangements like prices, quantities and mechanisms between loans and equity are still possible, as it is backed by the loans from the parent commercial bank. 

v) Return risk: In either investment and loan linkage or market-based debt-to-equity swap, pilot commercial banks expect the shares of the real enterprises (including technological innovation enterprises) held by their subsidiaries to appreciate in stock market trading (or equity transfer). Then, they can gain the off-balance sheet returns that are higher than interest and improve the profit source structure. With the credit support from the pilot commercial banks, the investment targets of their subsidiaries may be better than those chosen by general investment companies or PE institution. That justifies their expectation for earnings from equity premium. However, that’s just part of the calculation and excludes other considerations. First, if a subsidiary’s registered capital is RMB 10 billion and the corresponding reduced size of credit is RMB 100 billion, the pilot commercial bank will lose RMB 2.5 billion of interest income annually when the deposit and loan spread is 2.5%. If it takes three years for the investment target of the subsidiary to go listed, the pilot commercial bank will lose RMB 7.5 billion of interest income at least. Second, as the subsidiary holds a limited number of shares of the real enterprise (a financial investor generally holds a 5% stake; those that hold more than 10% stake will be among the top 10 shareholders and will face tougher restrictions concerning reduction of the holding of shares after the company is listed), even if the invested real enterprise goes traded, there is a limited number of shares to be reduced based on the trading price, and whether the premium earnings from the sales of shares can be realized, is uncertain. Due to restrictions by different factors, the risks will be higher if some of the invested enterprises find it hard to list or transfer shares.

Advancing Deleveraging by Real Enterprises is a Viable Option

Combining equity with debts through the banking system, such as the investment and loan linkage and market-based debt-to-equity swap, to improve the investment function of pilot commercial banks is one possible way for a real enterprise to lower the leverage ratio, but is not the only way. According to the Opinions of the State Council Concerning the Positive and Steady Reduction of Enterprise Leverage Ratios, measures to lower the leverage ratios of real enterprises include actively advancing enterprise mergers and reorganization, improving the modern corporate system and strengthening self-discipline, activating stock assets in diverse ways, optimizing corporate debt structures in multiple forms, converting creditor’s rights into equity in an orderly manner, implementing corporate bankruptcy in accordance with laws and regulations and vigorously developing equity financing.

From the perspective of lowering the asset-liability ratio through the capital market, either adjusting the debt structure or increasing capital funds can be embarked on. By April 2017, the balance of household savings reached RMB 62.3652 trillion, and the balance of non-financial enterprise savings totaled RMB 50.4219 trillion. If 10% of the funds can be converted into capital funds or medium and long-term debt funds, that will be of substantial significance to lowering the leverage ratio of real enterprises. Options for real enterprises to lower the leverage ratio may include the following aspects.  

i) Beefing up issuance of medium and long-term corporate bonds. Issuance of medium and long-term corporate bonds (particularly long-term corporate bonds) not only helps lower the asset and current liability ratio, increase the share of long-term assets in operation and ease the pressure on debt liquidity caused by short-term debts, but also advances the expansion of long-term investor behaviors and the healthy development of the bond market. Given the current conditions, we can first encourage large central enterprises, listed companies and large private enterprises to issue medium and long-term bonds and improve their credibility in the bond market. Meanwhile, we may help them improve the source structure of debt funds and reduce excessive dependence on commercial bank loans.As for the listed companies that hope to raise funds by issuing more shares, we can encourage them to raise funds first through issuing medium and long-term corporate bonds and transfer the expanded size caused by issuance of new shares to the to-be-listed companies, so as to promote the increase in the number of listed companies.

ii) Beefing up issuance of preferred stocks. Preferred stocks are the securities products between common stocks and bonds, and combine features of bonds and common stocks. The funds raised by issuing preferred stocks can be included into the capital funds of real enterprises, and expanding the size of preferred shares will help relevant real enterprises increase capital funds. In March 2014, CSRC released the Measures for the Management of Pilot Business of Preferred Stocks, clearly defining the conditions and procedures for listed companies and non-listed companies to issue preferred stocks, the types of preferred stocks, the rights and interests of the shareholders of preferred stocks and the trading of preferred stocks. Although the preferred stocks have gained certain development over the past years, they still enjoy much room for further expansion.

iii) Restricting the transfer of funds to financial operation by non-financial listed companies. Recent years have seen some non-financial listed companies expand operation into the field of finance and purchase various kinds of wealth management products with huge funds, which accelerated the flows of funds from real business to fictitious business. According to Wind data, in 2016 alone, 767 listed companies invested RMB 726.876 billion in bank deposit products like wealth management products and structured deposits, wealth management products launched by securities companies as well as PE, trust, special fund and reverse-repurchase products, which exceeded 50% of the financing amount in the stock market. The funds raised by listed companies through share issuance belong to capital funds and should be used for development of real business; but once they are used for the purchase of wealth management products, the capital funds are converted into debt funds through the financial mechanism, which weakens the ability to expand real business. Therefore, regulation over the flows of funds from real business to fictitious business by listed companies shall be strengthened. 

iv) Restricting concentrated reduction of the holding of shares for cash by the shareholders of listed companies. Selling shares is the legitimate right of the shareholders of listed companies under the condition that shares are fully circulated. But some shareholders of listed companies take advantage of the mechanism for cashing and use the funds for financial operation. That not only causes a huge loss of funds in the stock market and adds to stock fluctuations, but also leads to the diversion of funds from real business to fictitious business. On May 27, 2017, CSRC released Some Provisions Concerning Reduction of Shares by Big Shareholders, Directors, Supervisors and Senior Executives of Listed Companies, providing new rules for the reduction of shares by the shareholders of listed companies. Effectively implementing the provisions is of great significance to curbing the loss of funds from the stock market and advancing the flows of funds from fictitious business to real business in the stock market.

v) Encouraging equity investment institutions to increase equity investment in real enterprises. China presently has a countless number of equity investment institutions, which own trillions of RMB of funds available for investment but find it hard to find desirable targets of investment (in terms of share price, investment size and equity circulation). The investment funds are an important force advancing the adjustment in the asset and liability structure of real enterprises; bringing into full play their role will be of substantial significance to changing the flows of funds from real business to fictitious business. To encourage equity investment institutions to input capital funds in real enterprises, we need to, on one hand, accelerate construction of a multi-layered stock market system and create better market conditions for share circulation and transfer, and, on the other hand, intensify guidance in industrial policies, administration openness and fiscal and tax policies.

vi) Further expanding the financing function of the stock market. The rules of trading define the layers of stock markets. In China, the main board market, SMEB and ChiNext all follow A-share trading rules and are actually stock markets of the same layer. It is hard for the trading rules at the same layer to meet the demand of numerous real enterprises that differ much in nature, structure, price, size and development, or to prompt stock market operators to constantly improve stock market mechanisms in competition. To effectively convert the surplus consumption funds of urban and rural residents into capital funds (rather than convert savings into debt funds), we must deepen the reform in China’s stock market, form a real multi-layered stock market system and expand the financing function through competition among stock markets at different layers. 

Developing the capital market is fundamental to lowering the debt ratio of real enterprises, and to the implementation of investment and loan linkage and market-based debt-to-equity swap in the banking system. In this sense, accelerating development of the capital market and construction of related systems is the essential path to effective deleveraging.

  

(The author is the Director of the Financial Institute of CASS and member of the Academic Committee of Shanghai Academy)