When Jean-Claude Trichet, president of the European Central Bank, made a market-moving speech on June 5, the fortunes of Chinese companies were perhaps not at the forefront of his mind. Yet in another blow to the increasingly discredited theory that Asia’s markets are immune to troubles elsewhere in the world, Trichet’s comments sparked events that led to widespread losses among Chinese corporates and could yet have further troubling consequences.
Details of these losses were recently brought to light on the blog of Michael Pettis, a professor at Peking University’s Guanghua School of Management, and have been confirmed by traders interviewed by Euromoney. They are worried: the losses – although not sufficiently substantial to threaten a serious outbreak of corporate failures across China – have been widespread and the foreign banks fear the end of their lucrative China-related derivatives business if the regulators clamp down on such activities.
The trade in question is complex and the details vary according to the client. However, a simplified example will suffice. A Chinese company borrows from a Chinese bank and agrees to pay 8% on the loan. It then enters into an agreement with the bank in which the bank pays back a few percentage points, so long as the euro yield curve does not invert.