Zhang Wenkui

Research Report No 97, 2001

I. Initial Effect of the Debt-to-Equity Policy

In the early 1990’s, to solve the problems of heavy debt of China’s state-owned enterprises (SOEs) and the resultant huge amounts of non-performing assets of national banks, some programs were put forward for restructuring the debts of banks and enterprises, including the debt-to-equity swap program with great influence (by Zhou Xiaochuan et al., 1994). After a few years of deliberation, the debt-to-equity swap program was accepted by the decision-making authorities in 1999 and put into implementation from 2000. It has become a policy of significant influence in recent years.

The debt-to-equity swap policy in implementation is some different from the initial program. According to the initial program, an investment department was to be set up in each commercial bank, what is actually adopted is to form 4 assets management corporations correlative to 4 commercial banks. The assets management corporations (AMCs) receive re-loans from the central bank and purchase the creditor’s rights to enterprises at face value from respective commercial banks, and transfer them into equity of enterprises, finally, all the AMCs shall exit from enterprises and repay the re-loans by selling equity and other means. The operation period of AMCs is temporarily set at 10 years, that is to say, they should within 10 years accomplish the expected goal of transforming debts into equity and exit from enterprises.

Viewed from its current progress, the debt-to-equity swap policy is being implemented smoothly with initial results. After strict and careful screening, the relevant departments recommended 601 enterprises for carrying out debt-to-equity swaps, with the suggested equity right reaching RMB459.6 billion. By the end of 2000, the majority of the recommended enterprises had concluded an agreement on debt-to-equity swap with AMCs and launched this policy. Among the 601 enterprises, the general enterprise survey team of the State Statistics Bureau conducted an overall survey of 504 enterprises that had signed official and framework agreements with AMCs, it shows that in the first year (2000) of debt-to-equity swaps, the enterprises involved in the swap would lighten their bank interest burden and most of them were expected to make profit. Published results of the survey indicate that, after completing the debt-to-equity swap, the average asset-liability ratio of each enterprise would fall from 68.68 percent to 45.62 percent, and their interest burden could be reduced by RMB3.723 billion monthly, enterprises expected to gain profit in 2000 amounted to 439, accounting for 87.1 percent of the total, of which, 92 could make a big profit. The asset-liability ratio of debt-to-equity swap enterprises even went down by a still larger margin in some localities, take Beijing for an example, in 2000 there were 17 SOEs that concluded a debt-to-equity swap agreement with AMCs, and after completion of debt-to-equity swap, their asset-liability ratio fell drastically to 38 percent from 77.3 percent, and likewise, most of them would benefit from a drastic fall of interest payment and make profit.

The asset-liability ratio has fallen, the debt is lightened and the loss-making enterprises began to make profit immediately. Does this mean that the expected target for debt-to-equity swap policy can be reached in 10 years and that the debt-to-equity swap policy is advancing towards the expected goal? As a matter of fact, the immediate emergence of profit was basically not brought about by the deep-rooted change in the enterprises, instead, the major part of profit was attributed to the change in their financial structure, in other words, less debt and interest payment has made their books look "better" than before. Temporary improvement in financial performance can not necessarily lead to any fundamental change in their situation, what is more important than the financial structure is the change in the structures of operation, property rights and governance (Zhang Wenkui, 1999).

In order to determine whether the implementation of the debt-to-equity swap policy is conducive to reaching the expected goal, we cannot but study the impact of this policy on the governance structure of enterprises. The impact of any kind of debt restructuring program on the governance system of enterprises is worthy of our attention, because it not only involves whether the restructured enterprises are able to fulfill their debt obligation in the future, but also has a bearing on whether they will establish a sound mechanism in a farther future under which all the responsibilities can be fulfilled and the interests of all parties be protected. International experience also shows that a perfect governance structure is of vital importance to the success of debt restructuring while an unhealthy governance structure will not be conducive to debt restructuring. According to a sample survey conducted by the World Bank to the debt-restructured enterprises in Hungary and Poland, it was not the creditors but the insiders of the enterprise who guided restructuring. Imbalance of information made it difficult for the creditors to understand the internal situation of the indebted enterprise, the creditors were usually put into the position of figureheads, therefore, not much improvement was made in the business performance of most debt-restructured enterprises (Zhang Chunlin, 1999). China’s debt-to-equity swap policy introduced AMC as the new shareholder of a debt-restructured enterprise. This has directly led to the change in the equity structure, and the interest and behavior-orientation of the new shareholder will exert an impact on the governance structure of the enterprise, and this is very important to our judgment on the prospect of debt-to-equity swap policy.

II. Debt-to-equity Swap and Governance Structure: International Perspective and Theoretical Probe

Modern capital structure theories believe that equity capital and debt capital play different roles in enterprises, and an appropriate capital structure is beneficial to both the increase in equity yield and the improvement of corporate governance. If, however, the capital structure deviates from the reasonable limit with too high a debt ratio, financial risks would be increased to the enterprise. When the enterprise incurs a debt service crisis, debt restructuring is usually more acceptable to all the parties concerned than liquidation after bankruptcy.

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