Appendix I. Using a Pilot Program to Restructure State-Owned Enterprises
Corporate debt restructuring should be implemented according to fundamental principles, namely, the rule of law, the observance of a market-based approach, the need to safeguard financial stability, and the avoidance of moral hazard. These principles could inform a pilot involving a small number of state-owned enterprises operating in a sector where there is clear evidence of overcapacity, and experiencing diverse degrees of distress. The pilot could be based on a predominantly out-of-court approach, conducted under the oversight of a SOE Restructuring Task Force consisting of the relevant institutions for corporate debt restructuring (such as the Ministry of Finance, PBC, CBRC, CRSC, NDRC and SASAC).
Once the target enterprises are selected, the pilot could proceed according to the following steps:
Step 1: Determining fair value of claims held by major creditors of the Target Enterprises. The CBRC would assess the fair value of the loans extended by the major creditors to the target enterprises, reflecting the losses in the banks’ books.
Step 2: Two alternatives: (a) sale of the loans, at fair value, to a newly established asset management company (AMC); or (b) establishment of a creditor committee by the relevant Banks. Both approaches require important preconditions, such as “safe harbors” for bank officials for restructuring or selling the loans; an appropriate governance framework for the AMC; and the participation of independent restructuring professionals. In any case, both approaches should be guided by the principle of value maximization.
Step 3: Restructuring/resolution of the Target Enterprises. The AMC/Creditor Committee would assess the viability of each target enterprise, comparing its going concern value and its liquidation value. For the non-viable enterprises, the most effective means of liquidation would be selected (including sale of business units). For enterprises that are viable, rehabilitation plans would be prepared by expert restructuring professionals. These plans should include both financial components (debt reduction, debt rescheduling and debt/equity conversions) and operational components (changes in business, sales of assets, change of management and layoffs). Creditors would have the ultimate decision on the plan, either through a vote under a master creditor agreement or by voting and obtaining the confirmation of the courts according to the insolvency law.
Step 4: Transfer of claims/ownership. Upon approval of the rehabilitation plan, the AMC would arrange for the sale of the restructured claims and/or of the newly acquired equity. Under the creditor committee approach, the claims could be retained but any equity would be sold. Equity could be sold to private investors or to SOEs with the appropriate governance mechanisms.
Step 5: Utilizing the restructuring fund. Given the shortcomings of the current unemployment insurance system, the restructuring fund would be used to assist laid off workers (transitional income support, targeted labor redeployment services and assistance in self-employment and other job creation programs).
Appendix II. Modalities of Debt Restructuring
Corporate debt workout could rely on various mechanisms and instruments:
In-court vs. out-of-court. Recognizing losses, developing policies to allocate them, and tightening budget constraints would encourage market-based debt workouts. Extensive use of out-of-court debt restructuring is necessary in situations where the capacity of the courts is limited (Garrido, 2012). In such cases, several countries reacted by creating enhanced out-of-court restructuring mechanisms/frameworks (Korea, Thailand, Indonesia, and Malaysia), or by introducing procedures with minimal court intervention (Spain, Portugal, Ireland, Slovenia; see EC Recommendation, 2014). In China, the capacity of the courts is also constrained. An enhanced out-of-court mechanism would allow for flexibility, while ensuring a degree of consistency in restructuring practices. The out-of-court mechanism should be based on structured workout principles, regulatory suasion to require all banks to sign on to the principles (including, if appropriate, master creditor agreements and arbitration clauses), and incentives and disincentives to promote the active participation of debtors and creditor.
Banks vs. AMCs. Banks may either keep distressed assets on their balance sheets and attempt recovery, or sell them to AMCs:
Bank-led restructuring. Banks generally do not have expertise to run or restructure a business, and state-owned banks are susceptible to political pressures. They also have incentives to hide impaired assets to avoid capital charges, and coordination among creditors can be difficult. Still, there are examples of a successful bank-led corporate restructuring. Conditional recapitalization with direct subsidies to restructuring departments of the banks has proved successful in the case of transition economies under similar governance and ownership structure as China (e.g., Poland in the 1990s).
AMCs. AMCs can help to dispose impaired assets and/or to expedite corporate restructuring. They can bring specific expertise unavailable in the banks, for instance by leveraging international technical expertise. But governance is key, as cross-country examples show that politically-motivated loans are difficult to dispose by a government agency susceptible to pressure. AMCs are even less successful in corporate restructuring in such cases (Klingebiel, 2000).
Are China’s AMCs fit for the job? The existing AMCs appear commercially oriented and they have built expertise during the cleanup of the banking system in late 1990s. But their past financial and operational performance is hard to evaluate given heavy policy distortions, such as inflated prices for purchased assets combined with an implicit subsidy through low financing costs. More importantly, despite steady progress in reforming commercial transformation including corporate governance, the experience of the previous bailout suggests that a mechanism should be firmly put in place to prevent political interference. The newly-established regional AMCs could potentially be more susceptible to such pressures. Ensuring independence and appropriate incentive structure is particularly important given the potential size and character of the new wave of impaired assets (Ingves, Seelig, and He, 2006).
Financial instruments. 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.5
Debt-equity conversion. It can play a role in addressing both bank and corporate balance sheets, as well as provide a means to restructure indebted firm by changing ownership and incentives. But, as discussed above, banks may not have expertise and incentives to proactively restructure the firms, especially SOEs. The ownership creates additional conflict of interest, as banks may keep lending to a now-related party, causing renewed indebtedness and hampering efforts to dispose of equity. Both corporate and banks may be also tempted to convert the assets at an unrealistically high valuation to avoid realizing losses. Key conditions for success include: strict solvency and viability eligibility criteria for corporates; a proactive approach of banks in their role as new equity holders (to support restructuring); limits in scope and time to bank ownership of equity (to reduce conflict of interest and improve incentives); and conversion at fair value, with recognition of losses.
NPL Securitization. The mechanism moves NPLs to another entity, helping clean banks’ balance sheets. The ownership structure of the debtor firm, however, is not directly affected. It does not directly help in corporate restructuring, although the restructuring powers are concentrated with an agent. Key disadvantages, particularly in China’s context, are: the domestic institutional investor base lacks depth; it is difficult to create a viable securitization market (as it requires good supporting legislation and well-aligned market incentives); it may transfer risk outside regulated financial sector to entities less able to absorb losses.
Distressed debt market. A more market-based system for resolving distressed debt would facilitate the disposal of NPLs. This may require greater involvement of specialist financial institutions and legal workout agencies, and would also benefit from better functioning collateral auctions to help increase recovery values. Existing AMCs can also play a role in jump-starting the market for distressed assets, provided they have the right incentives and independence.
Appendix III. China's 1998–2003 Previous Restructuring Experience
China undertook a substantial bank and corporate restructuring in late 1990s and early 2000s.
Appendix IV. Recent Near-Default Cases
Since mid-2014, there have been more than ten defaults or near defaults by SOEs and private bond issuers in the onshore corporate bond market. The recent episodes are mostly no surprise to the market given the sharp commodity price drop and severe overcapacity in certain sectors. On the contrary, some have been widely expected. Below is a brief review of a few cases as of May, 2016:
Chaori Co., a private solar energy manufacturer, defaulted on its coupon payment of RMB 89.9 million in March 2014. This is the first default case in China’s corporate bond market. Chaori later went through a debt restructuring, with outstanding payments on the bonds to be partly paid by the company and two guarantors including a national AMC.
China Shanshui Cement Group, a major private cement producer, defaulted on a bond payment of RMB 2 billion in April 2015. The debtor subsequently filed for liquidation.
Baoding Tianwei Group, a subsidiary of a central SOE and a manufacturer of electrical equipments, made the first case of SOE default in the onshore corporate bond market. The firm missed an interest payment of RMB 85.5 million due in April, 2015. Six months later, the company filed for restructuring, and eventually secured a bailout loan from a state bank. The investors started civil litigation.
Cloud Live, a listed company transformed from a restaurant chain to an IT service provider, made the first case of default on principal payments in April 2015. According to the company’s statement, it was short RMB 240.6 million ($39.2 million) needed to pay back RMB 400 million in debt it sold three years ago. The investors have filed a lawsuit.
Zhuhai Zhongfu, a major private producer of containers and packaging products, was unable to fully repay principal on its RMB 590 million corporate bonds maturing in May 2015. China Everbright Bank and the Bank of China limited its freedom to spend its capital.
China National Erzhong Group, a central SOE making smelting and forging equipment for use in power generation and aviation, warned investors about a possible default in September 2015. Consequently, its parent company, China National Machinery Industry Corp (Sinomach), acquired all outstanding bonds from investors, effectively insulating them from losses.
Sinosteel Co., a central SOE steelmaker, failed to pay interest due in October 2015 of RMB 2 billion ($315 million). State regulators subsequently stepped in, asking bond holders not to exercise a redemption option and postponing the payment.
Dongbei Special Steel Group, a local SOE steelmaker, failed to make a series of principal and interest payments on its commercial papers totaling around RMB 1.9 billion ($292 million) in March and April, 2016.
Shanxi Huayu Energy, a unit of a central SOE, defaulted on RMB 638 million ($98 million) due in April, 2016. Another 1.5 billion RMB in bond payments would be due later this year. The company, however, said that it would pay out on its overdue bonds after receiving a capital injection from its parent company.
China Railway Material, a central SOE and the nation’s largest supplier of railroad construction, requested to suspend trading of its debt instruments amounting to RMB 16.8 billion ($2.6 billion). The company is seeking debt restructuring.
State intervention has largely been ad hoc. There seemsno guideline defining the state’s role in SOEs’ defaults. NDRC’s involvement in the case of Sinosteel is seen as a strong administrative intervention, while the state’s role in Baoding Tianwei is more of a traditional financial support by state-controlled financial institutions.
The unprecedented bond defaults, however, have not systemically sparked market turbulence. Yields on five-year triple-A rated corporate bonds still stand close to the lowest level in history, and their spreads over sovereign yields remain narrow, largely reflecting the faith in government bailouts and loose liquidity conditions. Nevertheless, concerns on the rising number of defaults and on limited resources to bail out the troubled debt issuers have been gradually felt, as spreads began to widen, particularly for bonds issued by overcapacity sectors, and a few planned debt issuances were canceled.
Appendix V. Corporate Restructuring in Central and Eastern Europe
Hardening the budget constraint was critically important for successful transition to market economies. Several lessons emerged:
Several channels for soft subsidies need to be addressed simultaneously: direct subsidies, soft taxation, nonperforming loans, the accumulation of trade arrears between firms, and the build-up of wage arrears (Toth and Semjen, 1998).
Legislative changes to establish financial discipline are an important step. This includes bankruptcy laws to help enforce private contracts, accounting rules, and financial market regulations. Bankruptcies and liquidations were far less frequent in the Czech Republic than in Hungary or Poland, implying a softer budget constraint in the former.
Privatization helps harden budget constraints. It is difficult to establish financial discipline with political power and the management of the SOEs tied into a single bureaucratic hierarchy. Empirical studies show that privatizing SOEs generally brought a hardening of the budget constraint (Pohl and others, 1997).
But privatization per se is not sufficient. In the Czech Republic, Hungary and Poland, private sectors accounted for about three-quarters of production by the second half of the 1990s. However, the number of exits in Poland and Hungary were greater than in the Czech Republic, suggesting harder budget constraints:
Fragmented ownership does not promote hard budget constraints. The Czech Republic’s voucher privatization scheme resulted in fragmented ownership. Assets were concentrated in investment funds that were launched and managed by the still state-owned big banks. The close tie between the firms and the state was not severed, preserving the soft budget constraint (Kornai, 2001)
Severing the link with state is key. In Hungary and Poland, the private sector expanded mainly through the establishment of new businesses. The privatization of SOEs was largely in the form of sales and there was only very limited free distribution. Assets tended to go to investors with fewer links with the state and fewer expectations of state assistance. Both countries also had higher proportions of outsider owners and lower proportions of insider owners than the Czech Republic. Li (1998) noted that privatization to insiders tends to soften budget constraints.
Appendix VI. Korea’s Experience with Corporate and Debt Restructuring
Chaebols’ debt-heavy expansion came to an abrupt stop. During the run-up to 1997, profitability and returns on investment declined, leverage grew and interest coverage remained very low. By end-1997, liability-to-equity ratio for the thirty largest chaebols was 509 percent. Simultaneous distress among so many large chaebols was the key concern as Korea’s insolvency system was not capable of rapidly rehabilitating a large number of distressed chaebols, and neither Korean’s financial system nor the Korean public was prepared for massive financial sector losses.
The government used a multi-pronged approach to facilitate corporate restructuring (Mako, 2002). It included:
Encouraging banks (by Financial Supervisory Commission; FSC) to announce a withdrawal of credit, or “exit”, from 55 nonviable companies.
Government support for eight “Big Deals” to consolidate through merger, acquisition, or joint venture businesses in eight sectors suffering from excess capacity.
With encouragement from the FSC, 210 local financial institutions contractually bound themselves to the Corporate Restructuring Agreement (CRA) and embarked on workouts as an alternative to receivership and uncontrolled bankruptcy avoidance loans.
A number of important initiatives to promote corporate reform: improvements in financial disclosure and accounting standards; stronger shareholder rights and enhanced corporate governance standards; relaxation of legal constraints on foreign investment; liberalization of merger and acquisition rules; greater latitude for employee layoffs; improved unemployment insurance benefits; more streamlined rules on court-supervised rehabilitation; elimination of domestic cross guarantees; requirements to shed noncore affiliates and reduce leverage; tighter exposure limits on financial institutions; and action against anti-competitive intra-chaebol transactions.
Building several corporate restructuring vehicles.
Although modest progress has been made, the process did not fully address financial discipline. Oh and Rhee (2002) noted that the total amount of corporate debt remained virtually unchanged even though the liability-to-equity ratios have decreased (for example, from about 400 percent at end-1907 to about 210 percent at end-1999 for manufacturing sector) as corporations paid back the loans by issuing bonds with higher interest rates and rolled them over (debt-to-debt swap). Initially it created virtuous cycle as companies could avoid liquidity problem by issuing corporate bonds, contributing to the prompt recovery of the Korean economy after the crisis. However, the mechanism that produced the virtuous cycle had a critical inherent weakness in that it significantly reduced the chaebol’s incentive to restructure. Some chaebol, especially Daewoo—then third largest chaebol—kept on pursuing expansionary strategies financed by bond issues.
Appendix VII. Estimating the Impact of Restructuring
Estimation of the growth and employment impact from exit of nonviable firms includes three parts: the first part considers the direct impact at the sector level; the second part calculates the broader impact including inter-sector linkages and the second-round effect; the third part discusses the phase-in of such adjustment and the net impact on the economy considering labor reallocation to more productive sectors.
First-round effect. We identify the share of nonviable firms in each industry as the number of loss making firms divided by total number of firms. This share is then applied to the sector’s employment and industrial output to derive the first-round effect on output and employment. While the share in terms of number of firms may not be representative to the share of nonviable assets or employment due to the uncertainty in distribution, sector level capacity utilization rate is used as a cross-check. For the steel sector, given the large SOE dominance, output loss is assumed to be less than the employment cut, reflecting large surplus labor in the sector. For other sectors, output loss is assumed to be in line with the employment cut. The estimates show layoff of 2.8 million in the six overcapacity sectors, and 5 million in the construction sector. Associated output loss is 1.1 percent of GDP for the overcapacity sectors, and 0.8 percent for the construction sector.
Second-round effect. The six overcapacity sectors are mostly in the upstream sector, and spillover effect to other sectors are expected to be contained, a coefficient of 1.2 is applied to the first-round effect to mostly capture the impact on consumption from laid off workers (assumes 30 percent of wage cut and 0.6 propensity to consume). For construction sector, inter-sector linkages are stronger: a coefficient of 1.4 is applied to calculate the second-round effects. The estimates suggest output loss including second-round effect may rise to 2.5 percent of GDP.
Phasing-in the adjustment. The adjustment is assumed to be phased-in over three years, but front-loaded. The laid-off workers are expected to be gradually absorbed into service sectors, and the net output loss of the economy reflects the speed of labor reallocation and the productivity differential between the old and the new sector. The results show that net impact of overcapacity sector restructuring would be 0.6 percent of GDP loss in the first year, 0.2 percent in the second year, and close to zero in the third year. After the adjustment ends, GDP growth will be boosted by 0.2 percent in the fourth year.
Appendix VIII. Managing Local Government Debt—International Experiences and Principles
Principles: managing local government debt
Appendix IX. Projecting Growth and Credit under Different Scenarios
We project growth under two scenarios:
Proactive reform path. This scenario assumes a gradual corporate sector deleveraging coupled with full-implementation of structural reforms, which would lower near-term growth but boost medium-term growth to 6½ percent and stabilize nonfinancial private sector debt to GDP ratio (excluding LGFV borrowings) at 175 percent.
Old-growth model. This scenario assumes continued build-up of investment and credit, and no progress on structural reforms, which would increase near-term growth, but drive down medium-term growth to 5.1 percent. As a result, nonfinancial private sector debt to GDP ratio (excluding LGFV borrowings) rises to more than 210 percent by 2021.
Credit growth in each scenario is projected using two approaches:
Credit intensity approach. Credit intensity is measured as the amount of credit needed for one additional unit of output. Based on this definition, credit intensity in China has risen from a pre-crisis average of 1.1 to a post-crisis average of 2.7. This reflects both the surge in investment ratio and decline in investment efficiency, with large amounts of credit going to over-capacity sectors and loss-making enterprises. In the proactive scenario, with falling investment ratio and improved efficiency, credit intensity is expected to decline to 2.1, while in the old-growth model scenario, credit intensity will remain high with continued excess investment and lower efficiency. Indeed, before the Asian financial crisis, many countries in the region experienced a significant rise in credit intensity, including China (rising from 0.9 to 2). Nonetheless, after the large-scale debt restructuring, credit intensity fell on average to 1.2 for China and other countries in the region.
Flow of Funds approach. This approach projects credit flows required to finance corporate investment (taking into account investment intensity and profitability of the corporate sector), as well as flows within the corporate and household sectors. This allows explicitly linking credit projections with rebalancing and corporate profitability. In the proactive scenario, with the falling investment ratio and improving corporate profitability (reflecting higher productivity growth), external financing needs of firms will gradually fall over time. In contrast, corporate profits will decline further in the no-reform scenario, and more external financing is needed to maintain the high investment ratio, which artificially boost growth in the short-term. The within sector credit flow, especially inter-company lending, is also expected to stabilize in percent of GDP in the reform scenario, but continued to rise if the old growth model continues.
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We would like to thank James Daniel and Malhar Nabar, and seminar participants at the IMF and People’s Bank of China for valuable comments. We also thank Yingyuan Chen, Gongshu Luo, Jingzhou Meng, and Shamir Tanna for excellent research assistance.
Importantly, standard measures of credit in China classify credit extended to LGFVs as credit to the corporate sector. While formally classified as state-owned enterprises (SOEs) and not part of the public sector, many LGFVs perform fiscal functions and a sizeable part of this credit should be classified as public debt. However, even after stripping the effect of LGFV borrowing, credit to the corporate sector is still very high by the cross-country norm and rising fast.
Loss-making firms may experience only temporary stress and still be viable in the long-run. However, given the structural excess capacity in these sectors and consistently high share of loss making firms in the past three years, we assume that these difficulties are not temporary and that these firms should exit, with resources reallocated to more productive sectors. While this assumption could overstate the transition costs, the bias may be offset by the narrow focus on selected overcapacity sectors (ignoring loss-makers in other sectors).
These estimates include unemployment benefits, severance pay, transfer payments to partially cover health and migration costs and the fiscal cost of providing labor redeployment services.
See IMF Technical Notes and Manuals, 2016/05: http://www.imf.org/external/pubs/cat/longres.aspx?sk=43876.