China’s yuan carry trade marries Hong Kong’s derivate, and a beast is born

PUBLISHED : Friday, 01 April, 2016, 10:44pm
UPDATED : Monday, 27 June, 2016, 11:51am

Bank results have been bad, soured loans are soaring and profits are plunging. Scary stuff, but not scary enough for our George.

After decades in the banking industry in Hong Kong and mainland China, he now works at the Hong Kong branch of a state-owned bank. Life on the front lines hasn’t been kind to our veteran banker friend.

In the past months, he and his team have been busy cleaning up the dirt of “carry trade” – the business of borrowing US dollars to buy renminbi. In the heyday of sure-fire, one-way yuan appreciation, “carry trade” was a money machine. Thanks to the marriage of the Wild West banking up north and the creativity of yuan derivatives here, carry trade is now a guillotine.

Let us start with the simplest strategy, one with the least leverage. Say you were a private entrepreneur in Shanghai sitting on a cash pile of 10 million yuan thanks to the 2014 market rally.

The bank has sold you a wealth management product promising to pay back in three years with a compound interest rate of 10 per cent annually. If all went to plan, you would get 13.3 million yuan at the end.

Not bad. But wait, it gets a lot better. You pledge the wealth management contract with your bank and get a standby letter of credit (LC), which, in layman’s term, is a bank’s promise to pay.

Going by Risk Management 101, any prudent banker should only issue a LC of at most 90 per cent of your 10 million yuan investment. But in the highly competitive world of banking in China, there is no room for prudence. So instead of 9 million yuan, your banker is offering you an LC of 13.3 million yuan. In short, the banker assumes your wealth management product is as solid as a rock and that you will get all the compound interest as promised on maturity.

In reality, these products are nothing but loans to property developers and companies that lack the credit worthiness required for straight bank loans. Everybody in the world of finance knows this yet do not bother to factor in the risks.

Now, what do you do with the LC? Send it to your subsidiary in Hong Kong to import hundreds of pencils, or whatever. Your subsidiary gets a US dollar loan from your bank’s Hong Kong branch with the LC as collateral. Once again, for the full amount.

You don’t of course get to see the money because the bank has converted it into a yuan deposit promising an interest rate of about 3 per cent, if you are a conservative investor. But if adventure is more your style, the LC could happily end up in a leveraged derivative betting on another yuan spike.

Do not assume that only Chinese banks are playing this game. Almost everyone is. The banks get fat fees and you, double-digit gains. What’s there not to like?

But then, the bubble bursts.

The yuan decides to head south, and your phone can’t stop ringing. At the other end is our George, panting and puffing, he is asking for a margin payment. Unless you have spare cash to ease his breath, you would now have to sell your wealth management contract before the maturity date.

If you are lucky enough to get back all of your 10 million yuan investment, you are still 3.3 million yuan short that you have to cover from your pocket. Convert this into US dollar and you have taken an exchange loss of about 6 per cent.

In all, you are actually losing more than 40 per cent. That is, assuming you have not been naughty, such as getting multiple LCs with one single wealth management contract or taking out loans from more than one bank with the same LC – which is not uncommon, by the way.

In reality, it doesn’t, most of the time, end up with a simple payback with implied losses. Many can’t or just won’t pay when they get margin calls.

“They told us to queue up,” said George about the Chinese banks that issued the LCs. “It may take months. At least, we state-owned banks can jump the queue. Spare a thought for foreign banks. But what can one do? Taking a state-owned bank (that issued the LC) to court is not an option.”

Everybody gets hit when bets like these begin to unravel. Remember, the game started with wealth management contracts. When speculators force redemption of the contracts before the maturity date, who do you think gets squeezed? Property developers and less credit worthy companies that have been using the money, of course. Now we are talking domino.