Pimco Mystery-Meat Concern Drives Up China Lender Risk

Default risk for China’s banks climbed to a six-month high as a factory slowdown added to concern over what Pacific Investment Management Co. has dubbed the “mystery meat” in the world’s second-largest economy.

Contracts protecting against non-payment by Industrial & Commercial Bank of China Ltd., the nation’s largest lender, jumped 23 basis points this year to 155. Those for JPMorgan Chase & Co. rose two basis points to 69. Chinese and Hong Kong issuers accounted for four of the five biggest increases among Asian finance companies.

Debt is under scrutiny in China as payment difficulties emerge in the $6 trillion shadow-banking industry involving off-balance-sheet trusts and wealth-management products. Bill Gross, who oversees the world’s biggest bond fund at Pimco, said this week there is a “little bit of bologna” in China’s economy and nobody knows the extent of its problems.

“At the core of investors’ concerns right now are off-balance sheet items,” said Thomas Drissner, a Singapore-based investment manager at Aberdeen Asset Management Plc, which oversaw $321 billion of assets at end-2013. “Investors are unclear about repercussions for the banking system, which is why credit spreads widened. Bank credit-default swaps are also a prominent way for macro-driven investors to express a more bearish view on the economy.”

Shares Tumble

A gauge of Chinese financial stocks including ICBC and Bank of China Ltd. sank to a seven-month low this week in Hong Kong, after data indicated manfacturing slowed in January. The official Purchasing Managers’ Index showed growth was the least in six months, while a separate PMI released by HSBC Holdings Plc and Markit Economics on Jan. 30 indicated output shrank for the first time since August.

Shares of ICBC and Bank of China slumped 2.7 percent in Hong Kong this week. China’s domestic financial markets resumed trading today after the week-long Lunar New Year holiday. Credit-default swaps insuring China’s debt against non-payment climbed 14 basis points this year to 94 on Feb. 6 in New York.

China’s money-market rates have surged as the government pledged to rein in leverage and give market forces a more decisive role in allocating resources. The seven-day repurchase rate averaged 4.09 percent last year, compared with 3.5 percent in 2012, and was 5.41 percent today, according to daily fixings compiled by the National Interbank Funding Center.

Slowing Growth

The world’s second-largest economy will expand by 7.4 percent this year, the slowest pace since 1990, according to the median estimate in a Bloomberg News survey.

“Now with interest rates rising and GDP slowing down structurally, the sustainability of China’s debt burden becomes doubtful,” said Chi Lo, a Hong Kong-based senior strategist at BNP Paribas Investment Partners, which oversaw global assets equivalent to $646 billion as of June 2013. “This is a significant factor driving up China’s CDS, which ties to the worry about the Chinese banks due to their large exposure to informal finance and local government debt.”

China’s policy makers have attempted to rein in the unprecedented credit boom they unleashed in 2008-2009 amid the global financial crisis. Goldman Sachs Group Inc. analysts estimated in a July report that the nation’s total debt-to-gross domestic product ratio jumped almost 60 percentage points since the crisis, to almost 210 percent.

Shadow Banking

The size of China’s shadow-banking system could range from 30 trillion yuan ($5 trillion) to 40 trillion yuan, UBS AG economist Wang Tao wrote in a Jan. 27 report. More than 20 trust products totaling 23.8 billion yuan have run into payment issues since 2012, with about half of the cases still in legal process, Wang said.

“There is now such an uncertainty about shadow banking because the weaker the economy, the higher the likelihood that a default will occur,” Aberdeen’s Drissner said in a Feb. 5 interview. “It is well known that the regulators’ view on these issues is evolving and more likely than not its stance towards investors in those products bearing losses will change.”

The State Council, China’s Cabinet, has taken steps to rein in shadow lending, National Development and Reform Commission spokesman Li Pumin said Jan. 22 on a government website. Th China Banking Regulatory Commission said on Jan. 8 that lenders will have to publish data including off-balance-sheet assets and interbank liabilities.

Capital, Time

Chinese banks have enough capital and time to deal with an increase in non-performing loans, according to Edmund Harriss, who oversees around $100 million of yuan assets at Guinness Atkinson Asset Management LLC in London.

“A shadow banking sector isn’t a bad thing to have,” said Harriss. “It’s in this area that the cost of funds are market-determined. That’s a good thing. So you don’t just let it go. What you do is go back to the source of the problem.”

The offshore yuan withstood a rout in emerging-market currencies this year. The currency strengthened 0.4 percent to

6.0302 per dollar in Hong Kong, while non-deliverable forwards due in 12 months gained 0.1 percent. The Argentine peso tumbled 17 percent, the biggest loss among developing nations, and the Russian ruble lost 5.2 percent.

Lacks Transparency

There have been an increasing number of loans rolled over by China’s banks and a growing amount of borrowing is being done outside of normal banking channels, according to Jonathan Cornish, head of bank ratings for North Asia at Fitch Ratings in Hong Kong.

“Transparency continues to be a significant problem and there is no sign that is actually improving,” Cornish said in a phone interview on Feb. 6. “Whilst banks continue to lack a certain degree of transparency and have activities outside of balance sheets, there will continue to be some skepticism about stability.”

Investors in a 3 billion yuan high-yield product sold by China Credit Trust Co. and distributed by ICBC were offered repayment of principle on the Jan. 31 deadline, though the source of the funds was not disclosed. The product ran into trouble following the collapse of a coal miner that borrowed the money raised.

Pimco’s Gross said on Twitter that the bailout “sounded familiar as in 2008.” The losses investors incurred were too insignificant to instill market discipline and could even encourage moral hazard in which risks are ignored on the assumption of bailouts, Standard & Poor’s said in a Jan. 29 report.

Repayment Pipeline

About 72 billion yuan of collective trust products will be due for repayment in the second quarter, 20 percent more than in the three months through March, according to industry-analysis website www.use-trust.com.

“If growth slows down further and monetary policy remains prudent, the potential non-performing loans could get unveiled,” said Sophie Jiang, a financials analyst at Religare Capital Markets in Hong Kong. Defaults of commercially unviable enterprises would be good news for China’s banks, whose bad debt ratio was the lowest among key economies including the U.S., Europe and Japan as of 2012, she said.

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