[RTR2XED2] China is hooked on debt, and the policymakers' idea of treating the addiction could make things worse. Chinese officials said two months ago they will make it easier for commercial banks to swap problem loans in overindebted companies for stock, in a maneuver known as a debt-for-equity swap. The plan may allow conversions of up to $155 billion of bad loans, Bloomberg reported, which could help prevent struggling firms from default. This plan could, depending on who you talk to, simply move debt from one party to another, or alternatively incentivize the wrong kind of behavior. Gordon Orr, a senior adviser to McKinsey who sits on the board of Lenovo and Swire Pacific, wrote in a blog post Friday that China's army of investors have the most to lose from this debt fix. Here is Orr on the issue (emphasis ours): "The bank pays for its shares with debt that is worth less than the current market value of the shares. This dilutes the value of the remaining shares. The value of all the issued shares prior to the swap should go down. But the government’s hope is that the decline is slight relative to the daily ups and downs of the stock market and no one complains because their individual loss is so small. But small losses to many investors add up. IF $150 BILLION OF DEBT IS CONVERTED TO EQUITY AND, GENEROUSLY, THAT DEBT IS REALLY WORTH HALF OF THAT, THEN INVESTORS ARE TAKING A US$75 BILLION LOSS. That could cause a serious shakeup in the Shanghai market and prompt the government to intervene, Orr said. Chinese mom-and-pop investors seem unfazed by last year's August rout, largely because of faith in the government's ability protect their interests. Orr thinks that means more trouble ahead. He said: If investors get vocal, the cost of the debt equity swaps will be back on the government, albeit not the group that launched the swap program. It really will be a case of right pocket to left pocket. David Brown, a partner at PricewaterhouseCoopers in Hong Kong, wrote in The Financial Times last week that debt-equity swaps are an important and necessary step to sort out the country’s mountain of debt. But he also raises the question of where they will take place: Of course, if debt-equity swaps are mandated by the state or used only to patch up inefficient SOEs that might not be such a good thing. Although little known, there is precedent in China: banks were allowed to make equity conversions around the turn of the century at the same time as the big four asset management companies were established and in the boom years that followed some of these stakes may have done rather well. That's what scares the International Monetary Fund most too. While they cheered China's focus on excess corporate debt, they said the solution should be comprehensive and carefully calibrated. Here is IMF: Converting NPLs into equity or securitizing them are techniques that can play a role in addressing these problems and have been used successfully by some other countries. BUT THEY ARE NOT COMPREHENSIVE SOLUTIONS BY THEMSELVES—INDEED, THEY COULD WORSEN THE PROBLEM, FOR EXAMPLE, BY ALLOWING ZOMBIE FIRMS (NON-VIABLE FIRMS THAT ARE STILL OPERATING) TO KEEP GOING. Even the ruling Communist party itself sounded an alarm in a recent commentary, saying 'zombie' companies should be allowed to fail or go bankrupt, as debt-to-equity swaps are expensive and self-deceiving. Watch out. Join the conversation about this story » NOW WATCH: FORMER GREEK FINANCE MINISTER: How I dealt with stress when Greece nearly defaulted
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