What China Could Learn from the Debt-for-Equity Schemes of Yesteryear
Following the Treaty of Utrecht, which concluded the War of the Spanish Succession, both England and France found themselves hopelessly mired in public debt. Both, it turned out, hit upon a similar solution for trying to magic it away, and in the process sparked two of the more famous speculative crashes in world economic history. While the particulars in each case varied, however slightly, in both the South Sea and Mississippi Bubbles it was privately chartered banks that obtained charters for commercial companies in exchange for a basic debt-to-equity swap with their respective governments, which led to the financial frenzies that ensued. These cases illustrate the dangers of public-private partnerships, implicit or expected government guarantees, and the speculative booms easy credit conditions so often incite, all of which have their modern parallels, as we will see.
But to go back to the early eighteenth century, in England it was John Blunt and the Sword Blades Company, by that point a bank, which partnered with the British government to consolidate its debt, while in France it was John Law and his Banque Générale. Both institutions were unable, however, to buy up their governments’ massive respective debts. Therefore, they were granted charters for the South Sea and Mississippi Companies, respectively, with the expectation that both would work to further consolidate their governments’ debts via debt-to-equity swaps. Essentially, both companies were expected to convince individual holders of their countries’ respective public debts to exchange their short-term high-interest bonds for shares in the companies. The companies would then exchange those bonds with the French and English governments for long-term low-interest bonds.
To understand why this was, at least on the surface, attractive to all interested parties takes some historical context. In the cases of the governments of France and Great Britain, as well as the South Sea and Mississippi Companies, the answers are relatively straightforward: the companies would receive charters to operate their prospective businesses plus interest on the public debt, while each government would now see all its debt consolidated on a longer term and at a lower interest rate with a single friendly party with which it would be better able to negotiate. In the case of the existing government bondholders, however, we have to understand that holding government debt at that time wasn’t as safe or liquid as it would later become. First, as Carmen M. Reinhart and Kenneth S. Rogoff have shown, European governments prior to the nineteenth century regularly fell behind or defaulted on their public debts; second, government bonds were highly illiquid, with bondholders sometimes barred from selling their holdings in secondary markets.
All that remained was for the South Sea and Mississippi Companies to drum up sufficient public demand for shares of their companies to redeem the British and French debts. Here the two cases diverge, for though they were both wildly—if only briefly—successful, the ways in which each manufactured interest in their company’s shares differed. Where Blunt relied more on price manipulation and the bribery of members of Parliament, Law used public relations savvy and additional government commercial grants to spur public interest. Both, however, had their efforts buoyed by the obvious backing of their respective governments—which engendered public confidence—and by the overall paucity of other investment alternatives. Critically, both allowed buying on generous credit terms: as little as 10 percent down with nothing more owed for a year. Needless to say, this was like pouring gas on a fire. Both shares exploded in price, climbing hundreds of percentage points per month: from a beginning share price of just over GB£100 to GB£1,000 in the case of South Sea shares, and from FR£500 per share to almost FR£10,000 in the case of the Mississippi Company.
Blinded by the rapid paper fortunes to be made investing in these companies, the public had poured in. Almost immediately thereafter, however, things fell apart. Neither companies’ fundamentals justified their astronomical prices, and they lacked the money to actually redeem the shares at their current prices. With the initial enthusiasm now faded, and with eager investors queuing up to realize their massive new fortunes, both were faced with immediate insolvency. Investors lost much of what they had put in, the careers of both Blunt and Law ended, and only a bailout by the Bank of England kept the South Sea Company afloat. Both governments had achieved their goal, but with disastrous consequences for the average subject of their respective empires—particularly in the case the French, who suffered a tremendous bout of inflation after the Banque Générale tried to print its way out unsuccessfully.
Today, debt-to-equity swaps are commonplace, particularly among private firms, and are generally not deleterious to the broader economy—quite the opposite. One notable exception to this general rule is China. It first engaged in a deliberate debt-for-equity swap program in the 1990s, creating asset management companies to bail out the major state banks and several state-owned enterprises. Unlike in our previous two examples, what happens is completely internal, as it is the Chinese government sitting in all three seats—the state business needs money from the bad state bank, so the Chinese regime creates a new asset management company to take on the bad debts of both in exchange for equity in them. Despite the obvious absurdity of this closed-loop arrangement, it has worked well enough to keep kicking the debt can down the road. If anything, it arguably worked too well, convincing Beijing there was nothing it couldn’t accomplish through monetary, fiscal, or other economic intervention. China, not constrained by demands to be paid in specie, as the British and French governments of the eighteenth century were, has become addicted to the proverbial printing press. In fact, since it’s relaunching of the debt-to-equity swap program in 2016, China’s combined debt-to-GDP ratio has continued to climb.
Cut off from alternative equity markets, encouraged by the government to buy Chinese equities, conditioned by past experience to believe the Chinese state will always be ready to bail out any troubled institution no matter the problems, one cannot but feel sympathy for the cheated Chinese woman who threatened to kill herself publicly, right there at the packed house shareholders’ meeting, following Evergrande teetering up to the brink of collapse. Like so many of her fellow Chinese, her life savings had been in that investment. But the nature of the state is such that no government anywhere has ever cared about something so trivial as that when its own interests stand opposite.