Details matter in would-be debt-for-equity swap plan

China's debt-for-equity swaps, designed to shed 1-trillion-yuan ($154 billion) worth of underused capacity, have raised numerous questions about how the government will resolve the bad debts of inefficient companies, Caixin magazine recently reported.

Discussions about how China will deal with insolvent State-owned enterprises have been ongoing for months, but Caixin's report on Monday was the first to outline the scope of the plan to convert nonperforming, problematic and "normal" loans on the banks' balance sheets to shares in distressed companies.

Premier Li Keqiang indicated earlier that this would be a top-down, national strategy to alleviate the companies' repayment pressures, not a piecemeal response.

This is not the first time that the country has bought time for distressed SOEs. During a previous crisis in the late 1990s, the government created four special asset-management companies to buy about 1.4 trillion yuan of soured debt from the banks at face value. About 30 percent of those bad loans were swapped into equity as directed by the government.

There is similar precedent from just a year ago, when the central government allowed indebted local governments to issue 3.2 trillion yuan in low-yield bonds to swap for existing high-cost debt. Banks bought those bonds grudgingly, knowing long-term relationships with local governments trumped short-term loss.

Both cases are bailout plans with Chinese characteristics, highlighting the central government's persistent aversion to defaults and liquidation.

Bankers with the knowledge of Beijing's plan assured Caixin that only those companies with promising prospects that are suffering short-term distress would be included in the plan.

Zombie companies won't get the opportunities. Unlike in the late 1990s, this swap would be more market-oriented, with no state guarantees in the end. Still, questions abound about the details of how the bailout will work.

For example, how will zombie firms be identified, versus those promising companies that deserve bailouts? Local governments have plenty of reasons to lobby for SOEs in their jurisdictions to be selected. How will the bad loans be properly priced so the conversion is fair for both banks and companies? Will banks, after becoming major shareholders, participate in corporate management? It's an important question, because last time they didn't get the chance.

Also, how will debtors and creditors conduct the swaps? Will it be based on their willingness or will there be a government-assigned quota?

Policymakers face trade-offs dealing with such quandaries. Choosing not to bail out the poor performers carries risk, given that the size of China's nonperforming loans might be far larger than the headlines suggest. But turning the swaps into an "all-out" campaign also risks coddling banks and companies, whose irresponsible lending and borrowing over the past decade caused current woes.

Policymakers should make sure the swaps are market-driven, and that lessons stay learned.