UPCOMING WRITE OFF OF CHINESE BONDS – WHY YEAR END QUARTER GIVES MORE CLEAR PICTURE THAN ANY OTHER QUARTER OF CALENDER YEAR 

Recently we came across news about various institutions writing off Investments in Evergrande Bonds and booking Billion-dollar losses. Similarly, BFAM booking annual loss of $4 Billion on Chinese Real Estate Credit bets. So all in all many entities are in line to Book losses like Ashmore, HSBC, UBS etc. Now let us emphasize why year end quarter is more important than rest of other quarters. 

Accounting Practices 

(A)   Available-for-sale financial assets (AFS) are any non-derivative financial assets designated on initial recognition as available for sale or any other instruments that are not classified as  

(a) loans and receivables,  

(b) held-to-maturity investments or  

(c) financial assets at fair value through profit or loss.  

 AFS assets are measured at fair value in the balance sheet. Fair value changes on AFS assets are recognised directly in equity, through the statement of changes in equity, except for interest on AFS assets (which is recognized in income on an effective yield basis), impairment losses and (for interest-bearing AFS debt instruments) foreign exchange gains or losses. The cumulative gain or loss that was recognized in equity is recognized in profit or loss when an available-for-sale financial asset is derecognized. 

(B)   Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments that an entity intends and is able to hold to maturity and that do not meet the definition of loans and receivables and are not designated on initial recognition as assets at fair value through profit or loss or as available for sale. Held-to-maturity investments are measured at amortized cost. If an entity sells a held-to-maturity investment other than in insignificant amounts or as a consequence of a non-recurring, isolated event beyond its control that could not be reasonably anticipated, all of its other held-to-maturity investments must be reclassified as available-for-sale for the current and next two financial reporting years. 

General methodology for individual estimation of allowances  

When conducting a specific assessment for impairment (Loss in Value or Increase in Value), banks are expected to apply a true and fair view to the estimation of both the future cash flows and the collateral valuations (Security) based on the best practice included in this guidance.  

The estimated recoverable amount should correspond to the amount calculated under the following method:  

• the present value of estimated future cash flows (excluding future losses not incurred) discounted at the financial asset’s original effective interest rate; 

 • the estimation of the recoverable amount of a collateralised exposure reflects the cash flows that may result from the liquidation of the collateral.  

Banks should maintain in the credit file of the transactions the documentation needed so that a third party can replicate the individual estimations of accumulated credit losses made over time. This documentation should include, inter alia, information on the scenario used to estimate the cash flows it is expected to collect (going concern vs. Non-concern scenario (Entity is bankrupt)), the method used to determine cash flows (either a detailed cash-flow analysis or other more simplified methods such as the “steady state approach” or the “two-step cash-flow approach”), their amount and timing as well as the effective interest rate used for discounting cash-flows.  

The entity should establish and document the periodic procedures for checking the reliability and consistency of its individual estimations over the course of the various stages of the credit-risk control cycle. In particular, this periodic check of its individual estimates should be conducted by means of back-testing exercises whereby the entity assesses their accuracy by comparing them a posteriori with the actual losses observed on transactions. 

IFRS 9  

Forecasts of future economic conditions when calculating expected credit losses should be considered. The lifetime expected losses should be estimated based on the probability-weighted present value of the difference between: 

 1. the contractual cash flows that are due to an entity under the contract and 

 2. the cash flows that the holder expects to receive. 

Conclusion 

Going into technicalities it will be difficult for non-accounting field guy to understand what all this means for Financial market. Lets explain the same is layman language. 

Mr X from USA had huge sums of money. He has the potential to take risk and invest in risky Bonds. Looking at USA markets, he realizes he doesn’t have scope to get good return in corporates and Treasury. He looks at China with great source of return as the past data shows substantial growth rate. He is willing to invest in XYZ construction company in China giving 10% return as the currency is pegged so his dollars will not be subject to currency fluctuation. 

Till above, the story looks simple.  

Let’s assume he has net worth of $1 billion. He is willing to invest $100 Million i.e. 10% of folio in that company giving 10% yield. 

So year on year, he will get $10 million wherein he will beat inflation and real growth in wealth. After few years, Mr. X became more greedy and he thinks of investing his whole portfolio in Chinese companies. So he puts his money in their bonds. 

Seeing the deposit going from USA to China, Bankers start thinking about new product. So a manager comes to Mr. X and tells him about a new product. So Banker advises Mr. X why not to use your Bonds and securities and take loan from Bank against such Bonds. Pay 2% interest and earn 10% interest. So you will earn 8% net which will again beat inflation. The same appealed to Mr. X and he followed the advise of Banker. 

Bank being conservative followed safeguards of risk facility and advances $900 Million against $1 Billion bonds (offered as security) plus guarantee of Mr. X or property as additional security (Collateral). Till the time XYZ construction is giving interest, it will keep Mr X and Banker in a comfortable situation. Now here we can see that China is exporter of dollar in the form of coupon payment and Mr X and Banker are importers of dollar. So all in all, the benefit of pegged currency at cost of leverage is beneficial for both Banker and Mr X. 

But now lets assume that M/s XYZ Construction defaults on its coupon payments as well as Principal payment. Now what will happen? 

1. The Bond prices will fall dramatically. Lets say the value of $1 Billion comes down to 100 Million dollar. 
2. The Banker will loose security on Bond and unwillingly he will have to sell those bonds to cover his principal amount of loan or he has to ask Mr. X to provide additional security (collateral) against the same. Mr. X is no more the same billionaire as he put his 100% money in those junk bonds. 
3. Regulatory ratios will be at risk for Banks and they will be in need of more capital. So they will look for Central Banks assistance by mortgaging existing securities and borrowing overnight money. That’s what reverse repo and repo are telling globally. Central Bank will get highest rate of interest on its short term loans. That’s what inversion in yield curve is telling. 

SO in our above example we can see that how XYZ Construction failure created contagion effect in Banks’ books as well as on Mr. X. So replace Mr. X with Investment firms like M/s Ashmore and replace Banker with any other European or American Bank or Japanese Bank and replace XYZ construction company with Evergrande. 

All in all, what we are seeing is that earlier the dollars were easily exported and now this flow will stop immediately. The bankers will need to preserve capital as the capital exported by China will now be vanishing from the system as foreign creditors will get more than 70% haircut.  

The easy flow of dollar will stop which will force rest of the world to chase dollars. That’s what Dollar index is telling. Further since its year end, you need to bring your books near to actual and write off all such junk assets else your cash flow will reveal the real picture. The actual picture takes off the confidence from the system and forces your creditors to sit with cash. So all in all, the liquidity gets absorbed and people are left with notional profits. 

• By Nishant Maheshwari and Vishal Vora

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