China's plan to clear bad loans could backfire, IMF warns

China’s plan to rid banks of bad loans could backfire, allowing debt-laden “zombie” companies to stay afloat and creating conflicts of interest for bankers, International Monetary Fund staffers warned.

China is said to be drafting rules to make it easier for lenders to convert bad loans into equity stakes in debtor companies, or repackage non-performing loans and sell them as securities, Bloomberg reports, adding that the government has yet to release details of the proposal.

“While such techniques can play a role in addressing these problems and have been used successfully by other countries, they are not comprehensive solutions by themselves,” the IMF staffers said in a blog post Tuesday that accompanied a short report.

“Unless they are carefully designed and part of a sound overall framework, they could actually worsen the problem,” such as by allowing “zombie” firms to survive, they said.

Banks don’t generally have the expertise to run or restructure businesses, and debt-to-equity conversions could create conflicts of interest, the staffers said.

In a report earlier this month, the IMF estimated that 15.5 percent of commercial banks’ loans to companies – an amount equivalent to US$1.3 trillion, or 12 percent of gross domestic product – are potentially at risk.

Reported “problem bank loans” total US$641 billion, or 5.5 percent of banks’ corporate and household loans.

Debt should only be converted into equity for viable firms that have “operational” restructuring plans, the staff report said.

The debt should be converted at fair value, and banks should only hold equity for a limited period, the staffers added.

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