Earlier this month the top Chinese banks reported that they
increased their loan loss reserves by 300% over prior year reserve
As reported by Bloomberg, the five biggest Chinese banks
including Industrial & Commercial Bank of China Ltd.
(HKSE:1398.HK), China Construction Bank Corp (HKSE:0939.HK), and
Agricultural Bank (HKSE:1288.HK) have increased their loan reserves
to 349.9B Yuan, or 1% of total loans outstanding upping the
reserves over 22B from last year's 7.6B Yuan increase.
Is this the first sign of a Chinese banking system that is in
worse shape than most realize, or is this just a prudent move by
these banks in cleaning up their balance sheets?
Different Country, Different Rules
China's laws are different than most of the rest of the world when
it comes to loan loss provisions. Historically Chinese banks
had to get approval by the Finance Ministry to write off bad
debts. Courts also were typically involved.
In 2010, these rules were revised to make writing off
underperforming loans easier for the banks, and they are taking
advantage of it.
How Gold Experts are Misleading the Public
The accounting behind bad debt write-offs puts pressure on
today's earnings while helping clean up the balance sheet of bad
debts over the long term. When a company creates a loan loss
reserve, it results in negative earnings for the quarter offset by
a balance sheet account that reduces the outstanding debts
By writing off loans, Chinese banks are cleaning up their
balance sheets but at the expense of putting more pressure on their
income statements, which may be one reason the Chinese banks have
been falling in price.
Chinese Bank Risk
The fundamental question is how many of these loans are actually
bad and how much more will these banks write off down the
At the height of the U.S. financial crisis, loan loss reserves
reached as high as 3.5% of total loans outstanding from a starting
point around 1.25% of total loans outstanding in 2006.
One particular Chinese bank, Bank of Communications
(HKSE:3328.HK) , has already increased its loan loss provision
by seven times to almost 5B Yuan the first six months of
this year, lowering its earnings significantly more than if the
company had kept that bad loans on its balance sheet.
But overall, Chinese banks (NYSEARCA:CHIX) still have only
reserved 1% of their total loans outstanding as the China Banking
Regulatory Commission warns of a potential economic downturn. The
Commission is now urging its banks to write-off more bad
loans as earnings are ample at the current time. Some
thresholds now call for bank loan loss reserves to head to 2.5% of
total loans outstanding.
There is no secret of the ghost cities and the risks the country
and banks took in building up its infrastructure as growth
threatens to slow to its lowest level since the 1990s. Is it
possible the next financial crisis will actually come from Asia - a
place most least expect?
What the Charts Say
The following chart shows the recent breakdown in price of Chinese
stocks and ETFs. Shown on the top is the iShares China Large
Cap ETF (NYSEARCA:FXI) and in the middle is the broader Shanghai
Stock Exchange Index (SHANGHAI:000001.SS).
Both of these indices recently broke down from their uptrends,
showing the recently slowed momentum in Chinese stocks.
Another sign of China (NYSEARCA:GXC) slowing down is both
of these indices peaked in early 2013, but unlike the other markets
around the world, they have not made new highs.
This non-confirmation is similar to one we pointed out between
the VIX (CHICAGOOPTIONS:^VIX) and the S&P 500 (NYSEARCA:SPY)
just before we captured a 30% gain in the volatility index.
That trade is outlined by our article, "
Can Stock Market Volatility Stay Tame
" published on 10/11.
FXI recently broke down from its trend in place since the summer,
but it then found support at its 200 day moving average.
Meanwhile the Shanghai Index as a whole also broke down from its
uptrend but its 200 day moving average did not act as any kind of
The final chart in the graphic above shows the relative strength
of FXI to the Shanghai index. FXI's leadership recently broke
down, suggesting it will continue to lead lower.
Since FXI's 200 day moving average has held, it is not yet time
to sell out of Chinese stocks, but a breakdown in price below its
200 day moving average would align FXI with the Shanghai Index as a
whole in a declining trend and warning of a renewed downtrend in
Chinese companies (NYSEARCA:XPP).
If and when that 200 day moving average breakdown of FXI does
occur, buying the ProShares UltraShort FTSE China 25 (NYSEARCA:FXP)
would capitalize on a renewed downtrend in Chinese stocks and
Profit Strategy Newsletter
uses technical, fundamental, and sentiment analysis to stay ahead
of the market's moves. China may be the canary in the coal
mine as its banks are now the ones at most risk of a continued
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