How China’s Debt Fix Could Make Things Much Worse By IAN TALLEY in the Wall St Journal, Apr 26, 2016

Instead of China fixing a corporate zombie problem threatening to overwhelm the world’s second largest economy, Beijing may be about to create a bigger one.
That is the implicit warning in a new paper published by the International Monetary Fund late Tuesday.
Authorities in China are just starting to tackle the systemic build-up of two decades of credit-fueled and state-directed growth. The IMF estimates bad corporate debt in China—obligations owed by firms whose profits can’t cover interest payments—amounts to $1.3 trillion, a problem that could trigger bank losses equal to 7% of the country’s gross domestic product.
Such bank losses could rip through the Chinese economy, maim a growth rate already falling faster than expected and send shockwaves through the global economy.
That’s why the IMF wants to ensure the government gets its fix right the first time.
Beijing has proposed allowing banks to swap debt for equity in failing firms or bundling up those debts to be sold as securities.
The fund says such a plans could work, but only as part of a carefully calibrated and comprehensive program to deal with the mountain of bad debt weighing on the economy.
“They are not a comprehensive solution by themselves,” say the three authors of the paper, James Daniel, José Garrido and Marina Moretti. “Indeed, they could worsen the problem, for example, by allowing zombie firms (nonviable firms that are still operating) to keep going.”
The U.S. successfully used securitization and debt-for-equity swaps to wind down overleveraged industries in the wake of the financial crisis.
But, the IMF said, such efforts could backfire by allowing weak firms to keep going without an adequate overhaul.
“Getting the design right is critical,” said Mr. Daniel, the IMF’s China mission chief, and his coauthors.
The government should only allow debt-to-equity conversions for companies that have overhaul plans that can put them back into the black, the IMF said. Securitization of nonperforming loans requires a broad, diversified pool of bad debt, banks preserving some interest in the companies and a legal structure that gives creditors the power to restructure companies and sell assets a market value.
China’s legal system and the complicated relationship many of the companies have with the government could bedevil Beijing’s efforts, however.
Those and other policy challenges are why some economists are betting Beijing won’t be able to manage a smooth transition from a credit-fueled growth model toward one based more on markets and consumption.
And for plenty of global market turmoil ahead. http://blogs.wsj.com/economics/2016/04/26/how-chinas-debt-fix-could-make-things-much-worse/