G/SCM/W/575  
 
13 April 2018  
(18-2249) Page: 1/3 
Committee on Subsidies and Countervailing Measures  Original: English  
 
SUBSIDIES AND OVERCA PACITY:  
THE ROLE OF BELOW -MARKET FINANCING  
 
The following communication, dated 12 April 2018, is being circulated at the request of the 
Delegations of  Canada, the European Union, Japan, Mexico and the United St ates. 
 
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In a prior paper1, the European Union, the United States, Japan and Mexico raised the issue of 
subsidies and overcapacity referenced in Paragraph 10 of the Shanghai Ministerial statement and 
paragraph 31 of the Hangzhou Summit which stated:  
We recognize th at the structural problems, including excess capacity in some 
industries, exacerbated by a weak global economic recovery and depressed market 
demand, have caused a negative impact on trade and workers. We recognize that 
excess capacity in steel and other i ndustries is a global issue which requires collective 
responses. We also recognize that subsidies and other types of support from 
governments or government -sponsored institutions can cause market distortions and 
contribute to global excess capacity and the refore require attention.  
In the context of how the Subsidies and Countervailing Measures Committee (Subsidies 
Committee) could examine the question of the extent to which subsidies contribute to overcapacity 
and how they could be further disciplined, the following three questions have been posed:  
 
 To what extent have subsidies contributed to the creation of excess capacity?  
 What are the specific government or business practices that have contributed to the 
creation and maintenance of excess capacity?2 
 In what areas are current Agreement on Subsidies and Countervailing Measures 
(Subsidies  Agreement) disciplines incomplete or inadequate to address these practices?  
 
The purpose of this paper is to review particular instances of below -market financing; spec ifically, 
the provision of low -cost lending by state -owned banks to state -owned industrial enterprises to 
increase aggregate demand during times of severe recession, and subsequent steps taken by the 
relevant governments to convert the loans provided to eq uity ( e.g., debt-to-equity conversions). 
Often this type of lending is made without due consideration of borrowers ' risk and may be 
explicitly or implicitly guaranteed by the government.  
 
In our second paper3, we made the point that capacity is often creat ed pursuant to industrial 
policies to develop national strategic industries or to maintain the companies in these industries if 
they begin to fail. The overarching point in these instances of creation and maintenance of 
capacity is that the relevance of ma rket forces diminishes when the state – functioning as the 
leading economic actor – owns, controls, or influences large industrial enterprises and banking 
entities. Simply put, direct or indirect government ownership and control can result in political 
                                                
1 See, G/SCM/W/569; 14 October 2016.  
2 We now add "maintenance " in addition to "creation " as it is not only the original creation of excess 
capacity but the maintenance, or continued existence of such excess capacity, supported by government 
practices that is at issue.  
3 See, G/SCM/W/572, 13 April 2017; G/SCM/W/572/Re v.1, 24 April 2017. Sponsors included: 
European  Union, Japan, United States and Canada.  G/SCM/W/575  
 
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  considerations dominating what should be exclusively commercial decisions. This is especially 
problematic when the state owns or controls both the lender and borrower in a financial 
transaction.  
 
At the time of the Great Recession, some governments sought to stimulate demand by means of 
dramatically increasing low -cost lending by state -owned banks to state -owned industrial 
enterprises. This approach, combined with influential local governments – who may have been the 
owners themselves of important industrial e nterprises – seeking to grow their local economies and 
increase employment, results in a dangerous environment for the creation of additional capacity 
insufficiently justified by market factors. Indeed, in these circumstances, overly optimistic 
projections  of future demand, combined with abundant, cheap credit – explicitly or implicitly 
guaranteed by the government – prompts large -scale investment projects in capital -intensive 
sectors. The result is distortions in the domestic market that spill over into th e international 
economy and distort international trade patterns.   
 
Although state -owned banks providing an abundance of cheap credit to predominantly state -
owned enterprises may be an appropriate policy response to a severe economic downturn, to the 
extent that the creation of new capacity (or maintenance of economically unsustainable old 
capacity) is not market -based, the result could be oversupplied markets and excess productive 
capacity. This, in turn, can lead to a fall in prices and declining pro fit margins, potentially making 
repayment of loans taken out during the days of abundant cheap credit more difficult and a drag 
on company finances. More importantly, if there is not a properly functioning exit mechanism or 
government owners cannot make, a dmittedly hard, commercial decisions to readjust capacity, it 
becomes extremely difficult to re -align supply and demand. All too often these situations result in 
increased exports as the domestic economy is unable to absorb the increased production. The 
increased exports force industries in market economies to cut capacity and production to bring 
supply and demand back into balance.  
 
To address the problem of overleveraged state -owned enterprises following a period of abundant 
cheap credit, a government can , through state -owned banks or other financial institutions, convert 
high-interest bank loans to relatively low -return equity capital. This is a policy direction we have 
observed in some countries, in particular in those industries, such as steel and alumi nium, that 
have experienced overcapacity resulting from an abundance of cheap credit from state -owned 
banks and overly optimistic demand projections. While limiting debt -to-equity swaps to financially 
healthy companies has been the stated policy guideline,  we have seen such transactions in several 
steel companies that have been struggling financially. Indeed, there is a contradiction here. If a 
company is healthy, why would it need a debt -for-equity swap? Although debt -for-equity swaps 
can be structured to be purely commercial in nature, the conversion of debt to equity in a 
struggling company would only occur in a market economy in exchange for meaningful 
restructuring and management changes that would improve the borrowers ' long-term profitability. 
Normal investors would also be expected to demand discounts from distressed borrowers. The 
absence of meaningful company changes and debt being converted at face value would seem to 
indicate that, once again, tough commercial decisions cannot be made due to overr iding political 
considerations. These types of debt -equity swaps that are not on commercial terms therefore very 
often allow struggling companies to remain in business and to continue producing instead of 
cutting capacity or entering the bankruptcy and exi ting the market. This clearly exacerbates the 
overcapacity problem.  
 
The immediate question then is how should the subsidy disciplines be improved and strengthened 
to address the fact patterns described above, particularly given that some countries do not  fully 
comply with their notification obligations and knowledge of government subsidies is therefore quite  
meager ? One of the speakers at the seminar on the role of subsidies as a contributing factor to 
overcapacity suggested that a new paragraph be added to Article 5 of the Subsidies Agreement 
that would require a finding that a subsidy causes serious prejudice where the subsidy is specific 
and a Member 's capacity levels of a particular like product over a period of time have suppressed 
or depressed prices  of another Member 's like product .4 Is this a realistic standard? Can the 
capacity level of one Member be shown to suppress or depress prices for another Member? How 
should a country 's competitive advantage, or lack thereof, be taken into account?  
                                                
4 See presentation of Robert E. DeFrancesco, How WTO Dispute Settlement Can More Effectively 
Address Overcapacity , summarized in minutes of fall Subsidies Committee me eting; see: G/SCM/M/103, 
pages  22-23. G/SCM/W/575  
 
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The sam e speaker suggested amending Article 3 of the Subsidies Agreement to consider certain 
below -market financing by government -related entities as prohibited subsidies. The types of 
financing targeted are: (a) direct transfer of funds to cover operating losses ; (b) forgiveness of 
debt (taking into account bankruptcy laws or other insolvency proceedings); (c) loans to 
enterprises that are uncreditworthy; and (d) debt -for-equity swaps that are not on commercial 
terms. A direct transfer to cover operating losses – a former "dark amber" subsidy type – certainly 
appears egregious and a candidate for a stronger discipline. Should all instances of debt 
forgiveness be considered prohibited, even if a private bank under the same circumstances would 
have taken the same st eps? What is an appropriate policy response when an important business 
enterprise is faces insolvency? Should government intervention be contingent upon a credible 
restructuring plan designed to return the enterprise within a reasonable period of time to l ong-
term viability ? What is the proper definition of an uncreditworthy company? What are the factors 
to take into account when determining if a debt -for-equity swap is on commercial terms? If the 
financing that led to the debt initially was also on non -commercial terms should that be considered 
as well when determining if there is a subsidy element to the debt -to-equity transaction?  
 
While views may differ on these particulars, the central questions remain clear: under what 
conditions should below -market fi nancing be subject to stronger subsidy disciplines and wh at 
should those disciplines be?  
 
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