My Blog

July 31, 2008

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.

Comments (13) for "A better rating, but more de...

Quote: 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. Or if there is a provision of law that implicitly places this into the contract. I seem to recall that one issue in securitizing loans was that is very, very tricky in PRC law to resell a loan without having a default pass through to the buyer. One other issue is that if there is any sort of ambiguity in the law that will allow a PRC court to rule against a foreign bank, it will, and there is a lot of ambiguity in PRC securities and derivatives law. Also, there are very strict limits as to the type of derivatives that PRC banks can issue, and complex . So if a bank did issue a derivative against these regulations, it's legal unenforcable, but more likely someone came up with some clever way of getting around the legal restrictions, but if that is the case, then it is likely that the legal and counterparty risk was transferred to the foreign bank. One rule is to always be suspicious of cheap derivatives deals. When something goes wrong in derivatives deals, *that's* when you find out why you were getting the deal so cheap in the first place. Quote: 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. Or maybe not. If it turns out that the banks understood the problem and were able to pass off counterparty risk to foreign banks, then that gives us more confidence in Chinese banks, and less confidence in foreign banks. By Twofish - 7/31/2008 11:57 PM

Great blog, very glad to see you're bringing attention to this critical problem. David Webb has a similar post: http://www.webb-site.com/articles/toxicderivatives.htm As a side note: the company mentioned, Sinotronics (1195 HK), is the only one that I know of, where the Chairman has taken personal responsibility by indemnifying the listco against any losses. Rather unusual... Regulators in HK & the PRC should be preventing companies, especially listed ones, from entering into these kinds of agreements when there is no clear hedging purpose and when they are taking on huge "fat-tail" risk at the expense of outside passive minority shareholders. There's a line in the book FIASCO, where the trader describes a successful sale as ripping off a client's face. This is precisely the kind of behavior Chinese banks should not be engaging in - and something Chinese banks should not be learning from their Western counterparts (e.g. DB, Credit Suisse, etc.). Regulators need to stop babbling and start acting. By TK - 8/1/2008 3:47 AM

Twofish, I think you miss the point completely. If the Chinese banks had the contractual right to pass on their corporate counterpart losses to their foreign bank counterparts, it would be pretty silly for foreign banks now to be buying CDS on Chinese banks. In that case a Chinese bank default would hardly be the risk that needed to be hedged, and clearly that's not what's happening. The fact that Chinese banks refuse to post margin does not indicate that they have the legal right to do so, nor that the contracts allow them to pass on the failure of their counterparts to pay up. They implicitly purchased options from their corporate clients and sold them to foreign banks. Their corporate clients refuse to pay up, but that does not give them the right also to refuse to pay. There are rumors that one foreign bank is suing one Chinese bank, but in general most foreign banks don't want to sue for fear of harming what are important relationships. We may disagree, but it is pretty hard for me even in my most charitable mood to see this as indication of good risk management. Taking a dumb position and refusing to pay when you lose isn't an example of good risk management, and it only works to limit losses when the losses are small enough that your counterpart will let you get away with it. By Michael Pettis - 8/1/2008 4:04 PM

Thanks TK. Interesting site. I think I am discussing a very similar transaction to the Sinotronics one. The curve-inversion derivative was a pure punt and served absolutely no economic purpose, as far as I can see. The important thing to note is that in many cases, when these deals go wrong, the losses to the corporate borrower can be huge and can push them into default. This clearly impacts the lending banks. By the way Frank Partnoy, the author of FIASCO, is a friend and used to work for me at CSFB. He has a new book out, or about to come out, on Ivar Kreuger, the Swedish Match King of the 1920s. Great story. By Michael Pettis - 8/1/2008 4:18 PM

Cool, looking forward to reading it. FIASCO was just so tragically funny, I couldn't put the book down after starting it. Agree completely about those transactions. FD: I'm a shareholder of Sinotronics (albeit a recent one), and one of the things China really needs is more people like you teaching young managers how to allocate capital responsibly. There are just too many listed companies, who have directors and managers that do not understand capital allocation, who hoard cash and collect assets. I sent the CEO this article on Henry Singleton: http://www.observer.com/node/47348 I think they should modify the listing rules and require management and directors, who have not previously held public directorships, to take a "re-education" class, so that they can learn capital allocation properly with the essays of Warren Buffett as the textbook because the best protection from stupidity is education - the right education from Buffett. And by the end of the class, they should be able to answer this question and if they can't they should not be allowed to raise public money: If your company has $1 in cash per share net of liabilities, and your stock trades at $.60, you should: A) Invest in a new factory with an IRR of 10% B) Borrow more money at 6% interest, when you earn 1% on cash C) Buyback as much stock as you can D) Do nothing Most Chinese companies regrettably choose D, when the only right answer is C By TK - 8/1/2008 4:51 PM

Pettis: They implicitly purchased options from their corporate clients and sold them to foreign banks. Their corporate clients refuse to pay up, but that does not give them the right also to refuse to pay. Whether or not it does or doesn't depends on the detail of the contract, and in particular whether the bank was originating the option to the foreign bank or was serving as a broker for the corporation to the foreign bank. In practice, people tend to be relaxed about defining what is going on until something bad happens, in which case the lawyers have a field day trying to figure out what was agreed to. This is one big reason why NY, London, and Hong Kong are places where complex derivative trades take place, because if something goes wrong, the law is extremely clear about what happens. The law in Shanghai is much, much, much less clear, and being on the hook for several hundred million dollars gives you a big incentive for trying to use whatever ambiguities there are in the contract and in local law to get you out of a deal. By Twofish - 8/2/2008 12:30 AM

TK: There are just too many listed companies, who have directors and managers that do not understand capital allocation, who hoard cash and collect assets. My perception is that they *do* understand capital allocations and are undertaking polcies which are perfectly rational given the economic environment that they are under. Because the PRC financial system is undeveloped, corporations do not have stable access to cash, and if they don't hoard cash and assets, they can run into a situation were they need cash but can't get it. In addition, management compensation in the PRC is effectively based on assets owned by the company, rather than by profitability. If you own more factories and have more cash, you end up with a bigger salary and a larger office. It's a legtimate question whether this system is the most effective overall for the PRC. But my point is that people are responding rationally to the incentives that they are given, and if you want to change how they respond, you need to change the incentive structure. TK: I think they should modify the listing rules and require management and directors, who have not previously held public directorships, to take a "re-education" class, so that they can learn capital allocation properly with the essays of Warren Buffett as the textbook because the best protection from stupidity is education - the right education from Buffett. I think that is a horrible idea because what works in the United States, with extremely efficient capital allocation systems may work very, very badly in China which does have these systems. In particular, it was the large cash cushions that saved the banking system from collapse in the 1990's, and if we do have a economic crisis in China (or more precisely *when* we have an economic crisis in China), having companies with large cash reserves is going to help prevent the crisis from turning to a castastrophe. TK:      Cool, looking forward to reading it. FIASCO was just so tragically funny, I couldn't put the book down after starting it. Agree completely about those transactions. FD: I'm a shareholder of Sinotronics (albeit a recent one), and one of the things China really needs is more people like you teaching young managers how to allocate capital responsibly. There are just too many listed companies, who have directors and managers that do not understand capital allocation, who hoard cash and collect assets. I sent the CEO this article on Henry Singleton: http://www.observer.com/node/47348 I think they should modify the listing rules and require management and directors, who have not previously held public directorships, to take a "re-education" class, so that they can learn capital allocation properly with the essays of Warren Buffett as the textbook because the best protection from stupidity is education - the right education from Buffett. And by the end of the class, they should be able to answer this question and if they can't they should not be allowed to raise public money: If your company has $1 in cash per share net of liabilities, and your stock trades at $.60, you should: A) Invest in a new factory with an IRR of 10% B) Borrow more money at 6% interest, when you earn 1% on cash C) Buyback as much stock as you can D) Do nothing Most Chinese companies regrettably choose D, when the only right answer is C No it's not because: 1) There are lots of legal restrictions for what a company can do with its cash, and those legal restrictions are intended to prevent asset stripping. If you had US-style corporate law in China, then what would happen is that the manager would issue $1 million of shares to his cousin and then buy those shared with cash. To buyback shares would require the approval of not only the board of directors, but also SASAC and the state holding company parent of the SOE. Also it might cause problems. If you buy back shares on the open market, you reduce the fraction of shares that are "privately owned" and increase the fraction that are owned by the state holding company. This may not be a good idea. 2) Theoretically, you are acting in the interest of your shareholders, and if you have too much cash, your shareholders would want you to issue a dividend. Now suppose your big shareholder is the state who wants you to eventually issue a dividend but can't right now. They will get very annoyed if you buy back shares. 3) Maybe the market knows something. You could have a $1/share cash net of liabilities, but there could be some hidden liability that is obvious to everyone. Maybe your pensions are understated. Maybe your numbers look good, but no one trusts your numbers. Maybe your numbers look good and no one *should* trust your numbers. 4) It's also possible that the company is making large amounts of money loaning out their spare cash to informal money brokers. They could be getting 10% return on deals with other companies or informal financial intermediaries. Of course, making it obvious that they are doing this on the corporate reports may attract some unwanted attention. 5) Finally, and most importantly. Chinese companies (and Chinese people) have large cash reserves because in the past the have had situations were they needed cash very quckly. Imagine the Great Chinese Bank Crash of 2010 which was triggered by bad real estate deals followed by some bad complex options deals. At that point, you as CEO can no longer get loans for anything. That cash reserve is going to be the only thing that saves you. My experience is that people generally don't do business deals out of personal ignorance, and if Chinese companies are hoarding cash, it's not because they have ignorant business practices, but rather because they have, very, very good reasons for doing it, and if you don't think that it is productive, you have to understand why they are. Personally, I'm not convinced that it is such a bad thing that corporations have large cash reserves. Supposely it makes things less efficient, but having too little cash means that you are slightly more productive when times are good, and then totally dead when times are less good. I think that we are all going to be in much better shape if we don't talk about "IF" China is going to have a financial crisis. but rather what happens when China *does* have a financial crisis, China *will* have a financial crisis. All market economies have financial crises every few years. The important thing is to structure things so that when things get bad, they don't totally fall apart, and having large cash reserves does this. By Twofish - 8/2/2008 1:05 AM

TK: I think they should modify the listing rules and require management and directors, who have not previously held public directorships, to take a "re-education" class, so that they can learn capital allocation properly with the essays of Warren Buffett as the textbook because the best protection from stupidity is education - the right education from Buffett. Personally, I think that China needs to move away from this sort of "education." Defining education in terms of learning from a great master is a bad idea, and it doesn't matter whether that great master is Confucius, Sun Yat-Sen, Mao Zedong, Warren Buffet or Bill Gates. Maybe Buffet is right. Maybe he is wrong. Most likely he is right about some things and wrong about others and no one is sure what part is right and what part is wrong. Instead of going to a director of a listed company and saying "Warren Buffett says that you are wrong, Change what you are doing!!!" I think it is better to say things like "What you are doing seems to conflict with what Warren Buffett says you should do, can you explain why you are doing it?" and then listen to what the director has to say. My one view is that cash reserves are extremely important, and if you lower your cash reserves, you had better improve your risk management, and I don't think that Chinese banks and corporations have anywhere near the risk management it takes to operate at American levels of capital. Getting back to the points Michael Pettis is making, we certainly seem to be in agreement that Chinese banks have bad risk management skills, the question is "how bad?" Chinese corporations are likely to be worse. However having cash reserves means that your risk management skills can be less sharp, because you can end up doing something stupid, and not end up dying as a result of it. Education can be dangerous sometimes, because stupid people that know that they are stupid can do a lot less damage than smart people that are slightly less smart than they think they are. By Twofish - 8/2/2008 1:26 AM

Two Fish, I've tried to address your comments below. 1) There are lots of legal restrictions for what a company can do with its cash, and those legal restrictions are intended to prevent asset stripping. If you had US-style corporate law in China, then what would happen is that the manager would issue $1 million of shares to his cousin and then buy those shared with cash. To buyback shares would require the approval of not only the board of directors, but also SASAC and the state holding company parent of the SOE. Also it might cause problems. If you buy back shares on the open market, you reduce the fraction of shares that are "privately owned" and increase the fraction that are owned by the state holding company. This may not be a good idea. TK: I was referring primarily to Fujianese companies listed in HK (1076, 1195, 0572, etc.), not Mainland SOEs. I do not know of a single SOE listed in China (on the A-share or B-share market) that is profitable and trading at less than two-thirds of net current assets. In HK, companies cannot buyback stock without approval at an AGM and there is a % limit. Having said that, if the state can buyback shares on the cheap below any sensible threshold (e.g. if SOEs were trading at 2/3 of net current assets), then they should. Not only would that function as a market floor assuming China would be in a bear market, it would demonstrate that even the state can practice rational capital allocation. 2) Theoretically, you are acting in the interest of your shareholders, and if you have too much cash, your shareholders would want you to issue a dividend. Now suppose your big shareholder is the state who wants you to eventually issue a dividend but can't right now. They will get very annoyed if you buy back shares. TK: Why would the state want SOEs to issue dividends? If they buyback stock cheaply it is equivalent to paying a dividend because they grow book value per share (assuming they do it under the circumstances described above). The government can then monetize its holdings at a higher price in the future when it wants to. There are plenty of precedents for this globally (Link REIT, Telstra, etc.). The logic that they should maintain cash and do nothing because the government wants to collect a cash dividend simply does not make sense. 3) Maybe the market knows something. You could have a $1/share cash net of liabilities, but there could be some hidden liability that is obvious to everyone. Maybe your pensions are understated. Maybe your numbers look good, but no one trusts your numbers. Maybe your numbers look good and no one *should* trust your numbers. TK: Management knows the numbers, so there is no information asymmetry. I really don't know what you're getting at... You're making a moot point, if you can't rely on the auditors, then there is no basis for any conclusion. 4) It's also possible that the company is making large amounts of money loaning out their spare cash to informal money brokers. They could be getting 10% return on deals with other companies or informal financial intermediaries. Of course, making it obvious that they are doing this on the corporate reports may attract some unwanted attention. TK: This is precisely what a company should NOT be doing with shareholder funds. If they run a factory, they should not be using company money to buy real estate, trade stocks, etc. If they want to do that they should go start a bank. 5) Finally, and most importantly. Chinese companies (and Chinese people) have large cash reserves because in the past the have had situations were they needed cash very quckly. Imagine the Great Chinese Bank Crash of 2010 which was triggered by bad real estate deals followed by some bad complex options deals. At that point, you as CEO can no longer get loans for anything. That cash reserve is going to be the only thing that saves you. My experience is that people generally don't do business deals out of personal ignorance, and if Chinese companies are hoarding cash, it's not because they have ignorant business practices, but rather because they have, very, very good reasons for doing it, and if you don't think that it is productive, you have to understand why they are. Personally, I'm not convinced that it is such a bad thing that corporations have large cash reserves. Supposely it makes things less efficient, but having too little cash means that you are slightly more productive when times are good, and then totally dead when times are less good. I think that we are all going to be in much better shape if we don't talk about "IF" China is going to have a financial crisis. but rather what happens when China *does* have a financial crisis, China *will* have a financial crisis. All market economies have financial crises every few years. The important thing is to structure things so that when things get bad, they don't totally fall apart, and having large cash reserves does this. TK: This is all sensible from a macro perspective, but irrelevant to the micro-point that I have been making, which is that you have a dichotomy of listed companies in China & HK. Some that trade at absurd valuations and others that trade on the other end of the spectrum. The ones on the low end should be taking steps to enhance book value per share, rather than sitting on excess cash. When you buy $1 for $.60, you earn a risk-free return of 66%. If you spend the cash building a factory that will generate 10% returns on invested capital, you are making a stupid decision. I am not arguing that they should deplete their cash, but when a company has a current ratio of >6x, an ROIC in the mid-teens, etc. and their stock is trading at .5x net current assets, there is no reason not to use 10-20% of their cash to buyback stock. As for Buffett, I would say there are a plurality of smart capital allocators that Chinese managers can learn from. There is more than one road to every destination, but Buffett and Singleton are great starting points. By TK - 8/2/2008 2:36 AM

TK: Management knows the numbers, so there is no information asymmetry. I'm suggesting that because management knows the real situation, maybe that's why they aren't buying back the shares. The situation in which book value exceeds market cap also happened very frequently with high tech companies after the dot-com crash. The reason that companies didn't buyback stock was that cash was precious and they weren't going to get any more cash from anyone after the crash. If you spend cash to buyback stock then you have less time remaining before you have to make your operations profitable. For that matter the stock price was low because you just can't buy a company, stop operations, and distribute cash to shareholders. TK: You're making a moot point, if you can't rely on the auditors, then there is no basis for any conclusion. With PRC companies you often can't rely on the auditors, and in any case GAAP doesn't deal very well with off-book liabilities, even in developed economies. Also one thing I'd look very carefuly at is the value of the other assets that go into book value. It may be for example, that current assets include accounts receivable or real estate that are either worth nowhere near there stated value or could suddenly drop in value or can't be liquidated easily. TK: This is precisely what a company should NOT be doing with shareholder funds. If they run a factory, they should not be using company money to buy real estate, trade stocks, etc. If they want to do that they should go start a bank. From a shareholder value point of view, maybe starting a bank is more profitable than running a factory. In the United States you have an efficient financial intermediary system so that it's rarely an efficent use of shareholder resources to hold cash, and the point with high tech companies, who have to go through venture capital, is the exception that illustrates the rule.. China is very, very different. As far as starting a formal bank, you end up with regulatory reasons why you can't start a bank. I should point out that a lot of banks in the US (Chemical Bank, and Manufacturer's Trust) started out as manufacturing companies that became banks in large part because in the 19th century, it was easier to open a manufacturer company and then operate as a bank than it was to open a bank to operate as a bank. The same is sometimes true in China. It's dangerous for a financial system to have non-bank banks since they are undercapitalized, so before encouraging these companies to reduce their cash reserves, I want to see if they are effectively being a bank, and if they are being a bank, I want to make sure that they have good cash reserves. If they are operatng as a non-bank bank and it turns out that they do have good practices, I want to understand why. TK: When you buy $1 for $.60, you earn a risk-free return of 66%. (...) when a company has a current ratio of >6x, an ROIC in the mid-teens, etc. and their stock is trading at .5x net current assets, there is no reason not to use 10-20% of their cash to buyback stock. If you are getting a risk free return of 66%, you need to be asking yourself whether or not what you are doing is really risk free, and usually it isn't.. Also if the numbers are so out of whack, one really has to ask if there is something going on that the numbers aren't saying. I very, very seriously doubt that company managers are doing what they are doing out of ignorance. There is obviously something interesting going on here, and I'd find out what that is before trying to force them to do something differently. If you look at the story of "great financial disasters" one common theme is that at some point someone should have asked "so why am I getting such a good deal here." Also if you can point me to the balance sheet and website of a few of these companies, that would be very, very interesting to me since I'm curious about what is really going on here. By Twofish - 8/2/2008 5:46 AM

I was wondering if there were any other links to the Euro CMS situation, In particularly, there are references to an article in Caijng and SCMP that I can't seem to find. There are a few things that I'm puzzled by. The first is that the PBC and CBRC has tended to extremely conservative as far as the derivative transactions they have allowed Chinese banks to do because in every single situation since 1992, when derivatives trading has been allowed, it has been followed by some sort of disaster. So I'm wondering what caused the CBRC to allow yuan quanto Euro CMS, oir if was the case that they didn't allow it and banks came up with a loophole. (And since there is money to be made, I have often been astounded at the Rube Goldberg structures that people come up with in finance.) The second thing that puzzles me is the reaction of the foreign banks. In most cases, if a client doesn't meet a margin call, then you start taking their collateral and liquidating it, and generally, you don't have any choice in the matter. Required collateral levels for margin calls are generally matters of external regulation rather than internal policy, so if someone doesn't have a sufficiently collaterialized account, you don't have any choice but take the collateral. If that isn't going on, then it means that there may be something more complex going on here. Usually, it isn't "they won't pay, boo hoo, we take them to court" but rather "they won't pay, boo hoo, we take their collateral and they take us to court." Finally, an inverted yield curve isn't a "once in a lifetime event." It's something that happens rather frequently. If you are trading a long term floating rate for a short term floating rate, you are being moderately stupid since short term rates are more volatile than long term rates. If you are trading a long term fixed rate for a short term floating rate to save borrowing costs, then you are being really, really stupid. Something that is funny if if it weren't so sad is to watch complex derivatives being sold in situations in which neither the buyer or the seller really knows what is being bought or sold. What's even funnier/sadder/scarier is when they are in a situation when neither the buyer or the seller really knows what is being bought or sold, but neither of them really cares since both of the figure they they will have cashed out when things blow up. Derivatives are like power tools, steroids, and shotguns. Very, very useful if know how to use them. If you don't, they can cause huge messes.... By Twofish - 8/2/2008 2:30 PM

I agree with your description of derivatives, Twofish, and although I am something of a derivatives geek, I oppose their too-rapid development in China because the markets here, for structural reasons, are primarily speculative, which means derivatives simply give more power to volatility-enhancing trading strategies (or pure punting). I think the buyers of the curve-inversion option simply didn’t know what it meant and how painful it can be when the “unlikely” event happens, and of course they didn’t enter into the trade for hedge reasons (it is hard to imagine what kind of economic exposure a Chinese company might have that might be improved by an inversion of the euro curve]. My understanding of why the foreign banks haven’t played tougher is that they get most of their China-related business from Chinese banks, and no one wants to sour relationships. By Michael Pettis - 8/2/2008 4:05 PM

Pettis: (it is hard to imagine what kind of economic exposure a Chinese company might have that might be improved by an inversion of the euro curve]. The only think I can think of is if a Chinese company is getting receiving short term interest rate dependent but has liabilities that are dependent on long term interest rates. In any case, non-financial companies are only supposed to use derivative products for hedging, and if there are cross-currency derivatives involved, then SAFE requires documentation that there is a legitimate business purpose going on and can block settlement if there isn't. One thing that does ring alarm bells is if a company was doing real hedging, then they would want to get the money in Euros, rather than in RMB. If a company wanted to get around currency restrictions however...... Pettis: My understanding of why the foreign banks haven’t played tougher is that they get most of their China-related business from Chinese banks, and no one wants to sour relationships. That is scary, since it can easily lead to "I'll hide your incompetence if you hide my incompetence" situations. Pretty soon everyone ends up covering everyone else's mistakes until the whole system goes down. One big rule in trading, is that there has to be a mechanism to pull the plug early in the game, and force people to realize loses before they become systemic problems. If you don't have systems for force people to lose money early on, you end up with more and more losses until something really, really bad happens. Also, I don't think this is good business for the foreign banks in the long run. The major reason foreign banks were let into the China market by the government was the argument that foreign banks would provide experise, discipline, and competition to local banks and help improve local banks. If foreign banks are covering up bad risk management in local banks, then this removes the only strategic rationale they have for being able to do business in China at all. It's far, far better to have your counterparty mad at you, than to have the regulators mad at you. The worst that your counterparty can do is to stop doing business with you. Regulators can cut your licenses and throw people in jail. The problem here is that sometimes the banking incentive system rewards perverse behavior. There is a lot of optionality in trader bonuses. If you win a bet, you make tons of money. If you lose a bet, then it doesn't matter to you bonus if you lose $10 million or $1 billion. Derivatve salesmen make bonuses by selling derivatives, and bonuses involve yearly behavior and not long term behavior. By Twofish - 8/3/2008 12:36 AM