Yellow Flags Ahead for Trading China

11/05/2013 7:00 am EST

Focus: ETFs

Chinese banks recently reported that they increased their loan loss reserves. But the question is whether this is a sign of a system in bad shape, or just a prudent move, wonders Chad Karnes of

Earlier this month the top Chinese banks reported that they increased their loan loss reserves by 300% over prior year reserve levels.

As reported by Bloomberg, the five biggest Chinese banks including Industrial & Commercial Bank of China Ltd. (IDCBY), China Construction Bank Corp (CICHY), and Agricultural Bank of China (ACGBY) have increased their loan reserves to 349.9B yuan, or 1% of total loans outstanding upping the reserves over 22 billion from last year’s 7.6 billion 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.

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 balance.

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 road?

At the height of the US 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, 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 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 (FXI) and in the middle is the broader Shanghai Stock Exchange Index.

Both of these indices recently broke down from their uptrends, showing the recently slowed momentum in Chinese stocks.

Another sign of China 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 (VIX) and the S&P 500 (SPX) just before we captured a 30% gain in the volatility index.

Click to Enlarge

Trading China
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 support.

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.

If and when that 200-day moving average breakdown of FXI does occur, buying the ProShares UltraShort FTSE China 25 (FXP) would capitalize on a renewed downtrend in Chinese stocks and ETFs

By Chad Karnes of

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