New Default, Merchants Bank Move Spotlight China Risk
A couple of headlines are underscoring the high risk that China’s financial sector could soon pose for both domestic and international investors, as the nation’s financiers look for the most creative but not necessarily the safest ways to raise money. In the first instance, China Merchants Bank (HKEx: 3968; Shanghai: 600036) has officially joined the nation’s big national banks in a move to Europe, choosing the free-wheeling Luxembourg market as its first destination. Meantime, media are reporting that yet another domestic Chinese financial product is about to default, joining a growing list of such distressed high-yield offerings.
The big theme in all this is that Chinese financiers still have a lot to learn about risk management, especially since none have ever really experienced a major economic downturn. That reality means that many believe they can engage in high risk activities without fear of negative consequences. Many also probably believe that stability-obsessed Beijing will come to their rescue if any of their high-risk decisions ultimately turn sour.
In the first new such high-risk move, Merchants Bank, one of China’s top regional lenders, has formally received permission to set up its first European presence in the tiny country of Luxembourg. (English article) The bank made the move as Luxembourg prepares to sign a yuan clearing agreement with China’s central bank, which will allow local banks to more easily do business in the Chinese currency.
The agreement would follow similar clearing arrangements in Britain and Germany, and is part of Beijing’s drive to internationalize the yuan. One report points out that Luxembourg is already home to Europe’s biggest yuan deposit base, totaling 79 billion yuan ($13 billion) at the end of this year’s first quarter, up 24 percent from the end of 2013.
China Merchants’ move to Luxembourg will put it alongside 3 of the country’s largest banks that are already there, namely ICBC (HKEx: 1398; Shanghai: 601398), Bank of China (HKEx: 3988; Shanghai: 601398) and China Construction Bank (HKEx: 939; Shanghai: 601939).
Media are reporting that most of the big China banks have recently begun shifting more of their European business to Luxembourg due to complaints about tighter and uneven regulation in other countries. To me, that looks like they’re choosing Luxembourg due to its famously loose regulatory environment. That sounds like a recipe for excessive risk taking by these inexperienced banks, and accordingly I would advise anyone buying yuan products from Chinese banks in Europe to avoid anything with the “made in Luxembourg” label.
Next let’s look quickly at the latest looming default from a financial product in China’s domestic market. This time it’s the attractively named “Credit Equals Gold #2” high-yield product that’s on the verge of missing an interest payment, according to media reports. (English article) The product was sold to wealthy individuals who should have understood its high risk, and is backed by 1.3 billion yuan in debt issued by a struggling coal company in Shanxi province.
The coal company could miss a payment due July 25, at which time the product would officially go into default. The name of the Shanxi coal company isn’t given, but this particular case looks almost identical to another high-yield product backed by a similar coal company that was sold through ICBC and defaulted earlier this year. (previous post) In that case an unnamed savior, most likely a state-run firm acting under government orders, paid off the debt to placate angry investors.
Solar panel maker Chaori Solar (Shenzhen: 002506) also made headlines earlier this year when it became the first company in modern Chinese history to default on a corporate bond. And last week, a timber company called China Forestry (HKEx: 930) reportedly missed an interest payment on its bonds. (previous post)
Most or all of these products that are now defaulting probably would have been rated as “junk” in the west. But no such widespread ratings system exists yet in China, meaning investors must closely read the prospectuses to really understand what they are buying. Look for more defaults as more of these high-risk products run into trouble in the next year, which will spell trouble for both buyers of the products and the broader financial sector.
Bottom line: Merchants Bank’s move into Luxembourg and a new default of a high-risk financial product highlight Chinese financial firms’ inexperience in risk management, which will lead to headaches in a building downturn.
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