MacroScope

A return to China’s offshore yuan bond markets, or “dim sum” as they are colorfully known in Hong Kong, may be sweet for Gemdale, a mainland property developer. But not all fund managers are smiling. The company raised five-year money at 5.63% amounting to 2 billion yuan. Not bad, considering that last July, it raised a lesser sum for a shorter tenor while coughing up nearly double of what it paid this time around. Add the fact that it did so by keeping to the same weak bond covenant and Gemdale seems to have pulled off a stunner.

But Gemdale doesn’t seem to be the only one. In recent days, issuers with weak bond covenants have discovered a ready market for their debt and at much cheaper rates. In theory, bond covenants can be divided into two halves: affirmative and negative ones. The former promises to pay bond holders on time while the latter forbids it from exceeding certain financial ratios such as interest paid/EBITDA, debt to equity, etc. And of course, they are secured by the company’s assets or backed by bank guarantees or letters of credit. 

But when theory meets reality (read: offshore hunger for yield meets hungry onshore Chinese issuers), financial “creativity” is the outcome. So mainland companies set up complicated structures to ensure they are able to keep regulators and ratings agencies happy while getting access to cheap capital quickly without having to negotiate labyrinthine approvals processes.

And has that system thrived. Fidelity Investments says Chinese offshore bond issuance is the fastest growing sub-set of the greater Asian dollar and the dim sum bond markets. Offshore issuance by Chinese companies in both the dollar and the offshore RMB markets have boomed over the last two years and the fund manager says 16 companies amounting to USD 9 billion have such structures.

Enter keepwell agreements. In Moody’s words,  they are used by China-incorporated companies to support offshore subsidiaries issuing debt. Unlike guarantee structures, a keepwell structure requires no onshore regulatory approval. (emphasis added) The agency has rated 19 bonds from 13 Chinese issuers totaling over $9.4 billion using these credit-enhancement structures.

Many blame America’s shadow banking system, where dangers lurked away from the scrutiny of complacent regulators, for the massive financial crisis of 2008-2009. Richard Fisher, president of the Federal Reserve Bank of Dallas, said in a speech on Thursday that he is now worried about the risks to China from its own version of the shadow banks.

During the recent credit boom fueled by the 4-trillion-yuan fiscal stimulus, off-balance-sheet lending by banks and private loans by nonbanks exploded. This shadow-banking lending activity accounted for an estimated 20 percent of China’s total loans in 2011. With the cooling of the real estate market and with slower economic growth likely in the near term, a large share of these loans could turn bad. And because these loans took place outside the view of regulators, the effect of a sudden disruption in repayment is virtually impossible to predict.

Fisher was highlighting this concern to suggest that, while China’s efforts to reform its currency system are welcome, the authorities must be careful not to open the country up to volatile capital flows at a time when the world financial system is already very fragile:

Reuters’s top news and innovation teams have put together a web site on the yuan and the debate over its revaluation. Particularly worth a look after the weekend’s statement by China that it would allow more flexibility in its currency exchange. You can access it here, but it looks like this:

Michael Pettis, a professor and China expert at the Carnegie Endowment for International Peace, has put together a thorough and informative look at all things U.S.-China trade. It’s well worth reading and watching the entire thing, but here’s a few highlights that jump out:

* We’re likely to see a significant increase in global trade tensions

* China will probably allow the renminbi currency to rise, but not by a lot

* There is a way to resolve those huge global imbalances but it will be painful and the chances of mustering the political will — in China, the United States and Europe — look slim.

A bit more on that last point: Pettis thinks that those three players need to “come to some kind of grand agreement.”

Is latte at Starbucks in China overpriced or is the local currency, the yuan, unexpectedly overvalued? The former is certainly more plausible, but it might be equally true that the yuan, if not overvalued, is at least not as undervalued as other measures suggest.

This conclusion would come from my proposed Grande Latte index, the caffeinated equivalent of The Economist's Big Mac index. The Grande Latte index, like its burger brother, is a light-hearted attempt to find a basket of goods that can be compared across countries to assess purchasing power parity (PPP) and, by extension, fair currency value. There are serious flaws, but I will save these for, ahem, the bottom of this blog.

The cross-country cost comparison of grande (i.e. medium in Starbucks-speak) lattes shows that the Seattle-based coffee chain's brew is rather dear in China. A grande latte costs $3.75 in the United States but $4.10 in China in dollar terms. It is even more expensive in Japan. The conclusion, that the yen is currently overvalued by 23 percent, accords well with the views of many analysts. But the idea that the yuan might be overvalued by 9 percent flies in the face of pretty much all conventional wisdom. It is also a drastically different perspective than that of the Big Mac index, which in its latest edition showed the yuan to be 49 percent undervalued.