Over the last few years banks have become more discriminating in extending credit, and the major commercial banks have all reported a sharp rise in profits for 1999. However, banks’ balance sheets remain burdened by nonperforming loans resulting from poor lending policies. (By Chinese standards, a nonperforming loan is one that has not been serviced for a year or more; the international standard is six months). About 20 percent of outstanding loans are officially considered nonperforming, most of them owed by large state enterprises. By international standards, some of China’s commercial banks are insolvent.

Inadequate capital and heavy nonperforming loan burdens are just two of the major problems faced by commercial banks. Another is their organizational weakness. China’s commercial banking sector is highly centralized, and while hugely overstaffed is short of personnel familiar with international financial practices. The banking system needs reorganization as well as recapitalization.

The financial restructuring of state enterprises and cleansing of the balance sheets of commercial banks have become more urgent as negotiations for China’s entry into the World Trade Organization (WTO) have gained momentum. WTO membership will commit China to a timetable for the lowering of barriers against imports and the entry of foreign firms into a wide range of industries. It will also involve the opening of domestic financial markets to foreign institutions. To prepare for increased competition, the Communist Party leadership has directed that the transformation of medium-sized and large state enterprises into modern, market-oriented firms be completed by the end of this year. The four main commercial banks are also to be transformed, into share-holding corporations with equity listed on domestic and foreign markets. This transformation is built on a reduction in banks’ nonperforming loans and their recapitalization.

The centerpiece of the financial restructuring of state enterprises and the four main commercial banks is the government’s plan for a massive debt-equity swap. The debt to be swapped is about half the outstanding loans of the banking sector. Broadly there will be two linked transactions, the swap of selected enterprise debt for equity, and the purchase of the swapped debt from banks.

The swap of debt for equity is intended to reduce the leverage (debt-to-equity ratio) of state enterprises—estimated to be around 70 percent of assets on average—provide them with additional funds for investment in technological upgrading, and pave the way for stock market listing. The purchase of the debt is equivalent to writing off the banks’ nonperforming debt and providing them with additional capital. Both processes have been going on for some time, piecemeal and on a small scale.

The institutional vehicles of the swap are financial intermediaries created for the purpose. There are now four such asset management corporations, each paired with one of the main commercial banks: Cinda (Construction Bank of China), Great Wall (Agricultural Bank of China), Oriental (Bank of China), and Huarong (Industrial and Commercial Bank of China). Cinda was the first to be established, in April 1999, and the others were set up in the last quarter of 1999, Huarong being the last.

Although paired with commercial banks, asset management corporations are meant to be independent financial institutions under the regulatory oversight of the People’s Bank of China (the central bank). However, their institutional links with the four commercial banks remain ambiguous and will need to be clarified as the debt-equity swap proceeds and the asset management corporations begin disposing of their equity stakes. Their initial capital of 10 billion yuan ($1.2 billion) each comes entirely from the finance ministry. They are expected to raise additional capital by selling bonds and, in time, by listing on stock exchanges. They are created for only 10 years, with the possibility of an extension by the central bank.

Given the massive financial benefits they promise, the swaps are keenly sought by state enterprises. By the end of 1999, 2,000 large and medium-size state enterprises had applied to participate in the scheme. Of these, 601 firms have been selected. To qualify, they must be loss-making large enterprises in industries designated by the government as "key" or "pillar;" they should have undertaken key state projects, the implication being that their debts result partly from obligations imposed on them by the government; and they should be potentially viable, with marketable products, a high level of technology, and good operational and managerial structures. The plan is to swap debt worth 459.6 billion yuan ($5.4 billion), 53.1 percent of the total outstanding loans of the banking sector at the end of 1997.

The swap will consist of two transactions. The asset management corporations will purchase the designated debt of the commercial banks with which they are paired at face value, not, as would be the case in a market economy, at a knock-down price. They will also acquire an equivalent equity stake in debtor enterprises, which may be sold to a third party or bought back by the enterprise. Enterprise managers and existing owners want to have the option of purchasing back their equity, but asset management corporations are opposed to any restrictions on the disposal of their equity stakes.

It is accepted that the proceeds from the sale of the equity will fall short of the outlays on the purchase of the debt. Unlike debt-equity swaps in market economies, China’s is loss-making by design and has no immediate costs for the enterprises or banks involved. The finance ministry is committed to covering the deficit of asset management corporations. Although this guarantee is not open-ended, it may prove very costly for the government.

The debt-equity swap program should, over the next few years, lead to a huge expansion of China’s equity market and overseas listings. It will also facilitate an organizational restructuring of enterprise groups. It is, however, highly unlikely to solve all the major problems of the state industrial and financial sectors. After the swap, the government will still have to deal with many poorly performing state enterprises.