(Reuters) - China’s central bank is preparing regulations that would allow commercial lenders to swap non-performing loans of companies for stakes in those firms, two people with direct knowledge of the new policy told Reuters.

A woman walks out of the headquarters of the People's Bank of China (PBOC), the central bank, in Beijing in this November 20, 2013 file photo. REUTERS/Jason Lee/Files

The new rules would reduce commercial banks’ non-performing loan (NPL) ratios, and free up cash for fresh lending for investment in a new wave of infrastructure products and factory upgrades that the government hopes will rejuvenate the world’s second-largest economy.

NPLs surged to a decade-high last year as China’s economy grew at its slowest pace in a quarter of a century. Official data showed banks held more than 4 trillion yuan ($614 billion) in NPLs and “special mention” loans, or debts that could sour, at the year-end.

The sources, who spoke on condition of anonymity, said the release of a new document explaining the regulatory change was imminent. The People’s Bank of China (PBOC) did not immediately respond to requests for comment.

“Such a rule change shows banks’ bad loans have risen to such a level that this issue has to be tackled now before it’s too late,” said Wu Kan, Shanghai-based head of equity trading at investment firm Shanshan Finance.

State banks have extended loans to government financing vehicles and state-owned coal and steel producers, so this policy can help give lenders time to deal with non-performing assets as China pushes supply-side reforms, Wu added.

The quality of assets held by banks is worse than it looks, analysts have said. To avoid stumping up capital and to protect their balance sheets, some banks have under-reported bad loans and under-recognized overdue debt.

The top banking regulator has warned commercial lenders to pay special attention to risks.

Warren Allderige, chief executive of Hong-Kong based alternative investment management firm Pacific Harbor, said the plan was positive for banks and the economy.

“It shows the government is “backstopping” the banking sector. It is also a clear sign that the government is strongly supporting GDP growth by assisting weaker companies and increasing the banks’ available capacity for additional lending,” he said.

Allderige, who has more than 20 years business experience in Asia, said the move would also reduce the risk of “moral hazard” in future bank lending.

“It keeps banks involved in realizing the economic value of their own defaulted loans,” he said.

CABINET APPROVAL

The sources said the new regulations would get special approval from the State Council, China’s cabinet-equivalent body, thus skirting the need to revise commercial bank law, which bars banks from investing in non-financial institutions.

Previously, Chinese commercial banks usually dealt with NPLs by selling them at a discount to state-designated asset management companies which, in turn, would try to recover the debt or re-sell at a profit to distressed debt investors.

The sources had no further detail on how banks would value the new equity stakes, which would represent assets on their balance sheets, or what ratio or amount of NPLs they would be able to convert this way.

On paper, the move would also represent a way for indebted companies to reduce their leverage, cutting the cost of servicing debt and making them more worthy of fresh credit.

Beijing has prioritized the closure of so-called “zombie” firms responsible for much of China’s corporate debt overhang, and has taken aim at overcapacity in industries such as steel and coal.

Lai Xiaomin, chairman of China Huarong Asset Management Co 2799.HK, the country's biggest bad debt manager, said he had no direct knowledge of the move, but would welcome such debt-to-equity swaps.

These would help companies “improve their financial situation” and “prevent the spread of financial risk”, Lai told Reuters. Coal, steel, real estate and machinery were among the sectors he thought most suitable for debt-to-equity swaps.

“(In China) credit to non-financial corporates has risen in the last five years from 120 percent of GDP to more than 160 percent in May 2015,” Jose Vinals, director of monetary and capital markets at the International Monetary Fund, said at an event in Mumbai.

“These vulnerabilities ... will need to be addressed strongly as the economy moves towards a more market-based financial system, including for the exchange rate.”