Yuan Derivatives Heighten Risks for Taiwan's Banks, Fitch Says

  • Banks' losses estimated at NT$79 billion if yuan slides 10%
  • Financial regulator has tightened scrutiny of such products

Taiwan’s banks face a rising risk of customer defaults as leveraged bets on yuan appreciation turn sour, according to Fitch Ratings.

China’s currency has dropped 3.1 percent versus the dollar since a surprise devaluation in August and Fitch estimates that a 10 percent slide could saddle Taiwan’s private-sector banks with losses of NT$79 billion ($2.4 billion) -- equivalent to 0.4 percent of their assets. That scenario, which the ratings company said is “unlikely,” assumes clients fail to honor 40 percent of their losses on derivatives that were bought to profit from yuan appreciation.

"The exposure highlights domestic banks’ weakness in risk governance and opportunism as they seek higher growth and earnings opportunities amid the highly competitive banking sector in Taiwan," Taipei-based Fitch analysts led by Sophie Chen wrote in a report dated Dec. 6.

Yuan-linked derivatives known as target redemption forwards incurred unrealized losses of about NT$50 billion after China’s devaluation, the financial regulator said in September. Scrutiny of the contracts -- which bet on the currency appreciating and terminate once a cumulative profit has been achieved -- had already been tightened last year as the currency’s first annual decline since 2009 led to losses, prompting the island’s authorities to warn of their risks and penalize some banks.

Most of Taiwan’s TRFs were sold when the yuan’s exchange rate was in the 6.35-6.50 range versus the dollar and are set to mature in the first half of 2016, Fitch said. The yuan traded at 6.4081 as of 12:23 p.m. in Shanghai and is forecast to weaken 1.4 percent to 6.50 by the end of June, based on the median estimate in a Bloomberg survey. Only one of 44 analysts in the poll predicts a drop of more than 10 percent in that time.

Citic’s Lesson

Sharp swings in exchange rates can have devastating consequences for holders of TRFs. Hong Kong-listed Citic Pacific Ltd. lost HK$14.6 billion ($1.9 billion) in 2008 and was forced to seek a bailout from its Chinese parent after using the contracts to bet on gains in Australia’s dollar, which tumbled 20 percent that year as the global financial crisis took hold.

Taiwan’s Financial Supervisory Commission is requiring more information disclosure on derivatives, though the risk of TRF losses isn’t significant for banks, Jean Chiu, deputy director-general of the banking bureau, said in September. The notional amount of the island’s yuan TRFs and discrete knock outs, a similar derivative, was NT$135 billion as of mid-August, said Chiu.

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