A better rating, but more derivative losses

Standard & Poor’s have just raised China’s long-tem sovereign credit rating to A+, based on its strengthening external position. In part this reflects China’s strong fiscal position – in June according to a release today by Credit Suisse, China’s consolidated fiscal surplus for the previous twelve months reached RMB 443.5 billion, equal to about 1.5% of GDP (although needless to say I am worried about hidden expenditures that may one day show up as contingent liabilities). But the upgrade mainly means, I think, that China has accumulated so much in the way of foreign currency reserves that it will have little difficulty in repaying its very limited foreign-currency external obligations.

Even though I am pessimistic on the domestic side, I agree with the S&P upgrade, and would even argue that China deserves a better rating. The authorities are so determined to avoid a 1997-style crisis that they have made it all but impossible for the country to face pressure on refinancing (or simply paying off) its external debt.

However, rising oil prices and increasing talk of coal shortages at home put a damper on the stock market today, with the SSE Composite down 1.2%, led by refiners and airlines, to close at 2802. Fan Gang, a member of the central bank’s monetary policy committee, is nonetheless pretty upbeat for the post-Olympics market. According to an article today in the South China Morning Post, he recently told a local magazine, the Xinmin Weekly, that since we have already seen an adjustment in stock market and real estate prices, there is no need to expect one after the Olympics. “We needn’t worry about the post-Olympic economy at all. How could [stock] prices drop any further?”

Perhaps he really believes that, or perhaps he is just keeping in step with the request by regulators to stay upbeat before the Olympics. About a week after foreign newspapers reported that regulators had instructed domestic fund managers and market participants not to say or do anything in the next few weeks that might hurt the market, the China Daily reports:

Top securities regulators have vowed to maintain stability in and strengthen supervision of the capital market to ensure orderly trading in the run-up to and during the Olympic Games. “Preparations should be made to deal with any emergency and prevent trading from being harmed by rumors or hackers’ attack,” Shang Fulin, chairman of China Securities Regulatory Commission (CSRC), said.

Meanwhile I think a new entrant has joined in on the battle of the RMB. According to an article in today’s Bloomberg:

The appreciation of China’s currency has hurt employment in the country’s east, where most exporters are based, Yin Chengji, a spokesman for the Ministry of Human Resources and Social Security said. “There has been some regional and structural impact,” he said in Beijing today after a news briefing. “But employment demand remains strong in central and western parts of the country. The overall employment situation is basically stable.”

The argument that a rising RMB is contributing to unemployment is now very widely proposed and accepted. This is going to make it very difficult once again to shift concerns back to China’s monetary regime, and I would guess that we are going to need quite a setback, probably in the form of inflation or a banking setback, before China’s monetary problems are addressed. This means, to me, that the adjustment, when it comes, is likely to be much more painful than necessary.

At any rate as these stories indicate, on the policy front there isn’t a whole lot new happening beyond the knocking of heads together to achieve (a very fragile and probably temporary) consensus in favor of growth over tightening and, of course, the endless hunt for security threats in the run-up to the Olympics.

On a different topic altogether, in my June 29 entry I mentioned that one of my former students had called me up to tell me about growing worries in the derivative markets. In my attempt to explain the problem on my blog I wrote the following:

According to him, a very popular recent lending structure involved lowering borrowing costs for corporate borrowers by having the borrower implicitly sell a complex derivative (this is a common, and often dangerous, way of lowering borrowing costs). Let me explain this as schematically as I can.

A corporation borrows some notional amount from a bank, for five years, and agrees to pay 8% on the loan. The corporation and the bank simultaneously enter into a swap, for the same notional amount, in which the bank agrees to pay the corporation 1% annually, as long as the euro interest rate curve is “normal”. Should the curve invert, however, the corporation must pay the bank some amount, typically 4 bps per day according to my source.

The net result is that the corporation is able to borrow money at 7% instead of 8%, and in exchange it agrees to pay a significant penalty if the euro curve inverts – something that is extremely unlikely to occur, the CFO is probably told. From the bank’s point of view, they are still getting 8% funding, because they simply strip the option and sell it on to the foreign banks, who have the capability and expertise to monetize the option.

It sounds great on the face of it. As long as the euro curve does not invert, and I am sure the corporate borrower is given reams of data showing how rare that occurrence is, everybody is happy. The corporation borrows at 7%. The local bank lends at 8%, and makes additional fee income by implicitly buying the option from the corporation at a lower price than it sells to the foreign bank. And the foreign bank gets to sell a fairly complex derivative whose pricing formula is opaque (in investment banking jargon, “opaque” means “I can get away with charging a lot”).

Unfortunately, from what I have been told, the euro curve has inverted, and has been inverted for over a month. Furthermore, it is deeply enough inverted that there is little expectation that it will normalize soon. Corporations have suddenly seen their borrowing cost mushroom. The transaction that had previously reduced borrowing costs by 1% a year was now increasing borrowing costs by 10% a year on an annualized basis.

About a week after I posted this a couple of newspapers, including the South China Morning Post, wrote stories about these transactions – the losses had become big enough to generate some attention. Last week another of my students called me up to tell me that the story hadn’t ended. He sent me this (slightly edited) email today:

Basically all the major foreign banks (i.e their credit portfolio managers) are buying protection against the Big Four Chinese banks to hedge their counterparty risk. Although there is a standard CSA signed between foreign banks and Chinese banks, as a matter of fact all the Chinese banks nonetheless have refused to settle margin calls on their mark-to-market losses in the Euro CMS trades they put on as a hedge against similar transactions with their corporate clients. 5yr CDS of ABC and ICBC is bid at around 170 bps, but nobody is willing to show an offer at all.

According to my student, and to explain the above, the cost of default protection against the Big Four has soared because all the foreign counterparts, unable to get margin posted as required by the derivative agreements and unwilling to take the Big Four to court, are now facing the possibility of credit losses uncovered by margin. They are running around looking to buy credit default protection, but there are few sellers. He goes on:

One of the things being discussed around here is that each of the Big Four probably has $1-3 billion in paper losses already.

I heard some of the contracts expire in September or December this year, and there is no sign of any normality of the inverted euro curves, especially when you have such a hawkish ECB. Given the liquidity and cash position of the big four Chinese banks, there is no worry of any credit event to be triggered so far. But going forward all foreign banks will definitely act in a more prudent way when dealing with Chinese banks whose credibility and professionalism will be given a big question mark after the recent unpleasant experience.

I remember in the late 1980s there were similar difficulties dealing with Japanese banks, who didn’t seem to understand many of the risks they were taking and refused to play by the rules, even after having agreed to them. After an initial rush to deal with them (Japanese banks, it seemed, were going to rule the world one day), most bankers and traders I know decided that they weren’t worth the trouble – I myself came to that decision in 1988 after a particularly annoying and difficult transaction – and stopped dealing with them.

My student tells me that the Chinese banks are refusing to settle with the foreign banks largely because their corporate clients won’t settle with them and pay up on the bet-gone-wrong. This, of course, should be irrelevant – a bank takes on only his counterpart risk, not the risk of his counterpart’s counterpart, unless it is explicitly agreed to in the contract. Chinese banks must keep to the terms of the deal entered into whether or not their domestic clients have done so. One explanation of why the Chinese banks may refuse to put up margin could be that these transactions are not well-known within the bank, and no loan manager wants to draw his superior’s attention to them. Requesting liquidity to post margin would probably elicit questions.

The scale of these losses isn’t huge, relative to the bank balance sheets, but the types of transactions entered into, and the responses to market losses, should set some alarm belles ringing. This isn’t the sort of information that should strengthen our confidence in the ability of local banks easily to withstand a slowdown.