Mainland banks take hit on derivatives
Last week's interest rate increase from the European Central Bank could have some unusual, unexpected and very unpleasant consequences for mainland companies and the banks that lend to them.
Last Thursday, the ECB raised its benchmark refinancing or refi rate to 4.25 per cent from 4 per cent in a bid to quell gathering inflationary pressure.
Immediately afterwards, however, ECB president Jean-Claude Trichet adopted a surprisingly dovish tone at his regular press conference.
'From here I have no bias,' Mr Trichet proclaimed, making it clear that further interest rate increases are far from certain. At the same time, the ECB trimmed its forecast for future inflation to 'above 2 per cent' from 'above 3 per cent', while playing up its concerns about weakening growth.
To financial markets, at least the message was clear - interest rate increases in the short term should serve to anchor inflation expectations, while the prospect of slower growth to come implies rate cuts further down the line.
As a result, the benchmark euro yield curve now appears flat to inverted, with the 12-month yield higher than yields at longer maturities (see the first chart below).
This is a reversal of the usual state of affairs - like the one that existed a year ago before the credit crisis (see the second chart) - in which longer maturities typically carry higher yields to reflect the higher risk of lending money over longer tenors.
By now you are probably wondering what this all has to do with mainland borrowers and banks.
The trouble is that as Beijing raised interest rates six times last year, taking the one-year best lending rate to 7.47 per cent, mainland banks responded by coming up with some innovative ways for customers to lower their borrowing costs. One was a derivative instrument called a 'yuan quanto linked to the euro constant maturity swap spread'.
Working on the Jake van der Kamp rule of thumb that every additional word in the name of a derivative customers should add an extra percentage point to the potential cost, this looks like a very expensive beast indeed, and so it is now proving.
Without going into too much detail, mainland companies borrowed hundreds of billions of yuan from their banks while entering into a contract that paid off as long as the euro yield curve maintained its normal slope, allowing them to lower their cost of funding by up to a full percentage point. The catch was that if the euro curve inverted - something deemed unlikely on past performance - they would have to pay a hefty penalty.
Now the unusual combination of rising inflation and slowing growth means the euro yield curve has indeed inverted, and mainland borrowers are facing ruinous demands for extra interest payments equivalent to an additional 9 percentage points a year.
According to rumours, some companies are responding by simply refusing to pay up. If so, that will leave the banks which sold these toxic derivatives out of pocket, as they have hedged their own exposure on international markets and must honour their obligations or see their counterparty credit lines slashed. For once in derivatives markets, it may not be a case of buyer beware so much as of the sellers caught with their trousers down.