Macro Monday:Debating debt/equity swap

Lukewarm markets: Last week H-shares fell 1.6% while A-shares softened0.8%. The debate on China macro has turned less intense. Most clients wetalked to recently agree that the markets were over-pessimistic three monthsago, but few could see any big positives either. The markets have turnedlukewarm lately as investors see limited up- or downside. In the week ahead,China is to publish a slew of key macro data, including 1Q16 GDP growth, forwhich the market consensus is 6.7% yoy (vs. 6.8% in 4Q15).

Debating the debt/equity swap: As the growth fears fade away, the hottesttopic recently is debt/equity swap, under which banks swap loans for equity ina company. In our view, the best guidance for the present is history so wepublished a report titled Debt/equity swap: What can we learn from the past.

In 1999, China did use debt/equity swap as a solution to dispose of bad loans.

On the positive side, the debt/equity swap 17 years ago did reduce thefinancing costs and leverage ratios for distressed companies, contributing tothe macro turnaround later on. However, the key issue was corporategovernance, as over the process banks could lose debt repayment as lendersbut without gaining the benefits as shareholders. Moreover, a poorly designedswap plan could aggravate capital misallocation by delaying the exit ofinefficient firms and worsening the soft budget constraints for SOEs. In anycase, while Premier Li said this March that “we can explore market-baseddebt/equity swap to lower corporate leverage”, the game is set to becomplicated among key players (local governments, SOEs and banks).

FX reserves rose again in March: China’s FX reserves rose US$10bn inMarch, the first increase since last Oct. Stripping out the valuation effect, theactual fall could be similar to this Feb but way better than the drop of~US$100 last Dec and this Jan. The positive reading is not too surprisinggiven the recent weakness in the US dollar. As we discussed many timesbefore, the single important driver for the RMB and China’s capital flows is thestrength of the US dollar. That is why we half-joked that China macro hasnever been so global macro (interestingly, an article from FT last week alsosuggested that global macro has never been so China macro). In any case,for the remaining eight months of this year, we expect the dollar index willcontinue to hold sway over the RMB and China’s FX reserves.

March data to show an uptick: This week, China will release a slew of keymacro data, including 1Q16 GDP growth. We expect growth data to improvein March, thanks to favourable base effects and policy supports (see our datapreview). Home sales were also very strong in March (Fig 30). While it’sunsustainable for sure, it could still help ease the housing inventory pressure.

As such, we expect property investment to rebound modestly to around 5% in2016. Meanwhile, three months ago, the dominant market concern wasdeflation, now more and more investors are worried about inflation. It makessome sense, as CPI inflation was 1.6% yoy last Dec but could rise to 2.5% inMarch. We are not too worried, as the recent rise in inflation is due to sharpincreases in pork and vegetable prices, which was more driven by supplyrelatedissues (such as cold weather). With the weather turning warmer andsupply ramping up, the food-driven inflation upturn will most likely provetransitory. That said, higher inflation and stabilized growth could still causepolicy to be less expansionary compared with the past few months, whilepolicy makers would spend more time on supply side reform under which theyvow to lower capacity, leverage, inventory and costs.