 Bloomberg Opinion -- From the looks of it, Beijing is effectively attempting to inject equity into its small and medium banks. That may help keep them alive, but wont do what regulators need from these institutions to support the coming wave of defaults, bankruptcies, and a weakening economy across Chinas corporate sector and households.Chinas State Council said last week it would allow local governments to use their so-called special-purpose bonds to help replenish the weakest link in the financial system capital buffers among regional lenders, which are operating in a more precarious environment than the countrys large banks.But it isnt so straightforward. Provincial governments will offer these instruments and then use the proceeds to buy convertible bonds issued by financial institutions. Earlier this year, central authorities increased the special-bonds quota, allowing for issuance of 3.75 trillion yuan 531 billion of such debt from 2.15 trillion yuan in 2019. Of this, around 380 billion yuan is available to support the banks, or a quarter of whats left for the rest of 2020, according to estimates from analysts at Nomura Holdings Inc.Previous attempts to clean up the banks have ranged from central bank-linked bailouts, shareholder changes, and looser regulatory requirements. Beijing has brought in local governments and other state-backed institutions to serve as conduits. However, what the system needs is equity. This measure perhaps comes closest.The urgency of the problem can be gauged by the focus brought by the highest levels of power to the 4,000 small and medium banks carrying the burden of China Inc.s recovery. Premier Li Keqiang told the cabinet that the lenders face insufficient capital and limited ability to issue loans, according to a release from the meeting, local news outlet Caixin reported. Around 15 of these institutions didnt meet capital requirements and another 13 were considered high-risk by regulators as of April, according to the central bank. Boosting capital buffers through convertible bonds is a solution that tries to make things work on paper. Once sold, the difference between intrinsic and face value is accounted for as other equity instruments as a part of their core equity tier 1 capital, CreditSights Inc. analysts note. If the bond doesnt convert, over time the equity recognition gets amortized to zero. How or if investors in this case, local governments will gain on the equity conversion isnt clear. Thats usually the appeal of such debt; the fact that its highly uncertain will no doubt be troubling for the holders. This recapitalization process is aimed at increasing the ability of banks to lend more. But theyre already providing lifelines to the legions of micro, small and medium enterprises that are struggling the hardest. Manufacturing Purchasing Managers Index data from last month showed their situations continued to deteriorate, dropping to 48.9 from 50.8 in May. Large enterprises rose to 52.1. That means the bad loans will keep coming for a while. The banks will have to find a way to digest them and absorb losses.This latest measure, then, points to the increasingly limited options that China has left to deal with its multi-trillion-dollar banking system. Last year, regulators resorted to bailouts, like the seizure of Baoshang Bank Co. and the case of Bank of Jinzhou Co., where the central bank effectively became a shareholder. Earlier this year, authorities said a plan to reform small and medium institutions was in the works and that shareholders would be scrutinized more.Yet the dilemma of Bank of Gansu Co. shows that supposed rescues arent always effective, and priorities may not be aligned. A state-backed provincial highway operator stepped in as the largest shareholder, but was dealing with its own balance sheet issues. Months later the company, which is also Gansu provinces biggest state-owned company, announced a 167.3 billion yuan refinancing to deal with debts on 37 government toll roads. It now plans to allocate around 30 billion yuan to new roads. The bank has said that it provides loans and carries out transactions for connected parties. Its hard to imagine how a situation like this helps a troubled lender. This past week, the banking regulator put out a list of shareholders that will be forced to divest their holdings in financial companies. A statement said that some shareholders have even used banks and insurers as ATMs, using illegal methods to misappropriate banking and insurance funds.Local governments are already struggling with such tangled situations as well as a broader economy hit by Covid-19. Now, theyre on the hook for troubled banks, too. Its unclear how the provincial convertible holders will repay their own special-purpose bonds. The debts cant be paid off using fiscal revenues and are project specific.The reality is that this is a makeshift measure. Beijing is stopping short of taking these institutions whose challenges are a product of its own regulations onto its balance sheet. But thats where they may be obliged to end up.This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.Anjani Trivedi is a Bloomberg Opinion columnist covering industrial companies in Asia. She previously worked for the Wall Street Journal. For more articles like this, please visit us at bloomberg.comopinionSubscribe now to stay ahead with the most trusted business news source.2020 Bloomberg L.P. 