Middlebury Career Services A subsidiary of the Industrial and Commercial Bank of China (ICBC), the world’s largest bank, has recently reached deals with seven Chinese state-owned enterprises to convert about 60 billion yuan ($8.7 billion) of unpaid loans into equity shares.

A report by the International Monetary Fund (IMF) followed. The IMF increased its forecast for China’s GDP growth by 0.3 percentage points to 6.5 percent. The report also warned that “slow progress in addressing corporate debt” posed a risk to the forecast.

China has been trying to dispel such fears, but in our view as previously discussed in This Week in Geopolitics (subscribe here for free), they are warranted.

Here’s why.

A looming debt problem

The news about debt-for-equity swaps and China’s claims to be over the worst of its corporate debt problems all sound good until one remembers this.

In October 2016, the Bank for International Settlements (BIS) reported that China’s corporate debt was 121 trillion yuan, roughly 169 percent of China’s GDP.

The IMF also noted the problem wasn’t simply a high rate of growth in Chinese corporate debt since the 2008 financial crisis. It’s the fact that corporate profits have steadily declined since 2009, while the leverage ratio has increased.

One of the obvious side effects of such unrestrained credit growth is a rise in non-performing loans (NPLs). China currently reports NPLs at 1.7 percent of total loans. But we have always taken Chinese statistics with a grain of salt.

We think the true figure was somewhere between 3 and 7 percent.

But the IMF report suggests the number of loans at risk of default is much higher. It estimates that non-performing and special-mention loans have risen above 5 percent. Meanwhile, loans potentially at risk account for 15.5 percent of all commercial bank loans to the corporate sector.

A catch-22

A State Council announcement said the government-backed debt-for-equity program would be launched “under market principles.” The State Council said they will forbid “zombie enterprises” from participating. Only companies facing “temporary difficulties” and with “long-term potential” would be entitled to swaps.

So, let’s take a closer look at some of the companies involved in the program.

BBMG Corporation and Taiyuan Iron & Steel (TISCO) both recently reached agreements with ICBC. BBMG Corporation is a Chinese cement producer and property developer that saw profits fall in 2017 by 17 percent.

Figures for the first half of 2016 look much better, but only because the first half of 2016 was the height of an overheated Chinese property market, which propped up demand for cement. Now that China is taking steps to rein in property prices, BBMG’s prospects are uncertain at best.

Seventy elder party members from Bejing arrive to commemorate the 121st Anniversary Of Chairman Mao's Birthday on December 25, 2014 in Shaoshan, Hunan province of China. ChinaFotoPress/Getty Images TISCO is in a far worse position. It finished 2015 in the red, to the tune of 3.36 billion yuan.

The point is that these are not good investments, and if the government was not interfering in the market, many state-owned enterprises in China would fold because they aren’t profitable.

Those investing in the debt of these unprofitable enterprises either have both a high tolerance for risk and an exuberant optimism, or are counting on another kind of political or financial benefit in exchange for their investment.

The propping up of unprofitable state-owned enterprises is a catch-22. If China lets the companies fail, the Communist Party risks its legitimacy and could set off unrest. But not letting the companies fail means continuing to shuffle debt around until the banking system can no longer handle it.

The end result will be much the same in both scenarios.