The headquarters of investment bank JPMorgan at Chater House in Hong Kong. (Philippe Lopez/AFP/Getty Images)The headquarters of investment bank JPMorgan at Chater House in Hong Kong. (Philippe Lopez/AFP/Getty Images)

Two of the biggest global banks, HSBC and Citigroup, announced they are under investigation by the U.S. Securities and Exchange Commission (SEC) for candidate hiring practices.

It’s believed that the investigations focus on the banks’ hiring of so-called princelings, or children of state-owned enterprises or government officials, in Asia. Companies have used this practice to curry favors with local politicians or business executives in order to win business, mostly in China.

Such probes into a widespread industry practice have long been expected, but they serve to further crimp the competitiveness of Western banks in an increasingly difficult market.

HSBC and Citigroup are not the only banks under inquiry. Goldman Sachs, UBS, and Credit Suisse have also received letters from the SEC seeking information related to hiring practices in Asia. The practice is widespread beyond the banking sector, as chipmaker Qualcomm last year was also investigated for hiring princelings in China.

Last November, New York-based JP Morgan Chase agreed to pay $264 million to settle U.S. probes into its hiring of princelings of well-connected officials and executives in China. JP Morgan was the first company to settle with U.S. authorities over hiring practices in China.

HSBC disclosed on its earnings call on Feb. 22 that the impact of ongoing SEC investigation and possible resolution could be “significant.”

‘Quid Pro Quo’

“JP Morgan engaged in a systematic bribery scheme by hiring children of government officials and other favored referrals who were typically unqualified for the positions,” said Andrew Ceresney, Director of the SEC Enforcement Division in a statement after the JP Morgan settlement.

According to Department of Justice records, JP Morgan bankers kept a spreadsheet to track the hiring of princelings, including their relationship to new business. An email from a Hong Kong banker—who copied then-head of JP Morgan’s Asia-Pacific investment banking—even inquired upon how to “get the best quid pro quo” deal from the parents of such princelings.

Amongst the hirings probed by regulators was Tang Xiaoning, the son of the chairman at China Everbright Group, a state-owned financial services holding for which JP Morgan was in initial talks for IPO issuance and other possible deals.

It’s a thin tightrope for banks. Investment banking is a relationship business, and the business culture in Asia emphasizes personal relationships, or “guanxi” in Chinese. In some cases, JP Morgan was on the receiving end of referral requests to hire such princelings by senior executives at existing clients, according to Department of Justice records.

Global investment banks were quick to rush into the Chinese market without the opportunity to build a solid foundation—cultivated over years of relationships.

The “quid pro quo” evidenced in the myriad JP Morgan emails obtained by regulators seemed shallow and lacked the presence of real “guanxi.” JP Morgan was far from the first bank to use its princeling hires as leverage. According to a Bloomberg report, JP Morgan ramped up its hiring program after the bank lost a key deal to competitor Deutsche Bank in 2009 because the client’s chairman’s daughter had worked for Deutsche.

It’s not hard to see how “quid pro quo” deals could be tempting for global banks operating in an often-inhospitable market. Banking is a protected core industry to the Chinese Communist Party, and Western banks have been losing market share to domestic Chinese competitors over the last decade. Advisors to companies raising capital often come across sensitive corporate financial data—information Beijing may not want foreign banks to witness.

Take a quick glance at investment banking league tables and it’s evident that foreign banks face an uphill battle in China. Many Western investment banks are retrenching their business in China. Among the top equities advisors in Asia-Pacific (excluding Japan), China International Capital Corp. is No. 1 and Goldman Sachs is the only non-Chinese bank among the top five bookrunners, according to Dealogic. And no foreign bank resides among the top five Chinese onshore debt advisors.

Why Is Hiring Princelings a Crime?

It’s common for U.S. corporations to hire the sons or daughters of American politicians and business executives. American universities also compete to admit the children of powerful politicians, business executives, and celebrities—with the hope of winning business, in their case fully paid tuition bills and possible donations.

But it seems companies operating in emerging markets face greater scrutiny over corruption. The ongoing SEC investigations and settlements reached so far are related to the U.S. Foreign Corrupt Practices Act (FCPA), which bar U.S. corporations from engaging in bribery overseas.

“The FCPA prohibit … authorization of the payment of money or anything of value to any person while knowing that all or a portion of such money or thing of value will be offered, given or promised directly or indirectly to a foreign official to influence… or to secure any improper advantage in order to assist in obtaining or retaining business for or with or directing business to any person,” according to the Department of Justice.

The regulators interpret the hirings of princelings to be bribes (thing of value) to Chinese officials in order to directly curry favors and win business.

In the most public case—JP Morgan—the bank’s hiring of princelings clearly wasn’t just a one-off idea or the under-the-table strategy of one department. The bank seemed to run a well-orchestrated but unfortunately named “Sons and Daughters” program. The plan was documented and recorded within memos and tracked on spreadsheets, and its specific goal was hiring princelings to win new business.

That is the difference between a “wink wink nod nod” arrangement and a documented program. And it came at a cost of $264 million to JP Morgan shareholders.

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Pedestrians walk past the People's Bank of China, the central bank of China, in Beijing July 8, 2015. (Greg Baker/AFP/Getty Images)Pedestrians walk past the People's Bank of China, the central bank of China, in Beijing July 8, 2015. (Greg Baker/AFP/Getty Images)

The U.S. Federal Reserve is poised to raise benchmark interest rates as soon as this week, which may bring wide-ranging impacts to China’s own economy and monetary policy.

The Chinese economy serving as backdrop has shown signs of slight improvement in recent weeks. October trade data was positive, according to state statistics, with both imports and exports increasing in dollar terms compared to a year ago.

Exports were flat (at 0.1 percent) but up considering recent strengthening of the dollar. Imports surged—up 6.7 percent—on higher inflows of commodities such as oil, copper, and coal.

Deflationary pressures also eased somewhat. China’s producer’s price index (PPI)—a measure of price of factory inputs—rose in November as prices of coal, steel, and crude oil all jumped. Consumer inflation also picked up more than forecast, and should continue to rise given the increase in PPI.

An expected series of U.S. rate hikes—December’s 25 basis points should only be the beginning—will continue to boost the dollar and exacerbate existing capital outflows which Beijing is trying hard to restrict. And with continued positive inflation figures domestically, People’s Bank of China (PBoC) could be pressured to tighten its own rates policy in the near future.

No End to Capital Outflows

A stronger dollar makes U.S. investments more attractive to the Chinese, considering recent depreciation of the yuan.

This could prompt Chinese investors and companies to continue searching for loopholes around capital controls put in place by Beijing to limit cash outflows. China has already spent a big portion of its foreign exchange reserves to manage a depreciating yuan. Any continued strengthening of the dollar will put even more burden on Beijing to burn through its remaining reserves.

PBoC’s reported foreign exchange reserves dropped $69 billion in November, a decline of 2 percent from October and the biggest monthly slide since January. China’s foreign reserves have largely been declining since August 2015 as the PBoC has sold dollars, and as the dollar’s relatively strength versus basket of other currencies increased.

Along with selling the dollar, Beijing is aggressively cracking down on cash leaving the country from companies and individuals. Consumers already face a $50,000 annual conversion limit. For companies, authorities recently barred foreign acquisitions of $10 billion or more, and instituted a new program where each transfer of greater than $5 million must be reviewed and approved by regulators.

BBG

(Source: Bloomberg)

A widening gap between onshore and offshore yuan prices points to further yuan depreciation—and possible outflows—ahead. Hong Kong-traded CNH (offshore) yuan fell 0.84 percent versus the dollar in the last week (ending Dec. 8) while CNY (onshore) dropped 0.41 percent. Analysts generally view the CNH to be an accurate predictor of future dollar to yuan direction as it is not restricted by Chinese regulators.

Tightening Rates and Chinese Corporates

With cash expected to continue to flow out of China, Beijing may have little choice but to tighten its own monetary policy.

If authorities choose to go down this route, corporate loan defaults could accelerate and some companies may find it difficult to service their debts and stay solvent.

To put it in context, China’s total debts stand at over 250 percent of the country’s GDP. Fitch Ratings sounded the alarm last week after it estimated that some 15 to 21 percent of all loans in China’s banking system are non-performing. Those figures have been widely suspected, but regardless it’s a staggering amount compared to official average statistics of less than 2 percent at the nation’s biggest lenders.

SHIBOR

(Source: Shibor.org)

After an initial flurry of corporate defaults early this year, few companies have been allowed to falter since. Instead of a massive wave of defaults like some analysts predicted, Beijing avoided such action by turning to more creative measures. Facing a slew of redemptions at maturity this year, state-owned companies employed other avenues to assuage the problem by using debt-to-equity swaps, and if the companies are still viable, issuing new bonds or using shorter-term financing to roll over long-term debt.

Until now, easy credit has made issuing new bonds cheap and easy. China financial data firm Wind Info estimates domestic bond offerings are up 44 percent year-to-date compared to 2015. But outside of the largest issuers, small to medium sized companies are increasing turning to short-term financing such as issuing commercial papers wealth-management products.

But these solutions are the most susceptible to interest rate fluctuations. If Chinese interest rates continue to rise, these strategies will no longer be viable.

The 3-month SHIBOR (Shanghai Interbank Offered Rate) has increased 12 percent in the last 60-day period to 313 basis points. Such increases in short-term interest rates may squeeze corporate financing activities and cause defaults at already cash-strapped companies.

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News Analysis
China Anbang Insurance Group’s sudden withdraw of its $14 billion bid for Starwood Hotels raises questions about Anbang’s source of financing, business model, and standing with the Chinese Communist Party regulators.
Anbang’s all-cash offer should be more attractive to shareholders on paper, but a person with knowledge of the deal told the Financial Times last week that Anbang had failed to demonstrate it had the necessary financing to back up the all-cash bid.
Starwood indicated that it was comfortable Anbang had the financing in place for its latest offer. But with Marriott likely preparing a sweetened bid should Anbang’s latest offer have stood, it was unclear if Anbang’s consortium—which also includes private equity firms J.C. Flowers and Primavera Capital Ltd.—would have been able to arrange enough financing to increase the bidding.
Circumventing Regulators
Information from China paints a different, and more convoluted, picture.
The China Insurance Regulatory Commission (CIRC) was considering blocking Anbang’s acquisition of Starwood, due to Chinese regulations barring domestic insurance firms from owning more than 15 percent of its assets in foreign investments.
Anbang already has a roster of foreign assets. It owns overseas insurance companies such as Iowa-based life insurer Fidelity & Guaranty Life, Belgian property-casualty insurer Fidea, and South Korea’s Tongyang Life Insurance. Last year it paid $2 billion for the Waldorf-Astoria Hotel in New York.
CIRC calculates foreign holding limit by using insurance assets only, and Anbang’s insurance assets are comparatively small. Out of its $293 billion (1.9 trillion yuan) of assets as of 2014, only $50.8 billion relate to life, property, and casualty insurance, capping its foreign holding at around $7.7 billion.
But something doesn’t add up.
Regulatory difficulties seem like an excuse—they have never been a problem for Anbang’s Chairman Wu Xiaohui. He is the grandson-in-law of the former Chinese Communist Party leader Deng Xiaoping, and Anbang recruits among former senior party officials.
A Chinese investment bank said Anbang intentionally reshuffled shareholder registrations over the years in order to skirt CIRC rules on insurance company ownership, according to Caixin, a Chinese financial magazine. CIRC rules state that a single investor could not hold more than 20 percent of any insurance company.
Caixin’s research also found that some of Anbang’s 39 investors are obscure outfits such as auto dealerships, real estate firms, and mine operators that sometimes use shared mailing addresses, many of whom are connected to Chairman Wu. Most of the investors bought their stakes in 2014 and together injected 50 billion yuan into the company. There’s also a trend of major state-level investors scaling back their ownership, with SAIC Motor Corp. and Sinopec decreasing their ownership levels from 20 percent each to 1.2 percent and 0.5 percent respectively.
A Chinese investment bank said Anbang intentionally reshuffled shareholder registrations.

When Anbang raised its offer to Starwood to $82.75 per share, Wu was telling Chinese media that the insurance company had around 1 trillion yuan to deploy, signaling Anbang’s global ambitions were hardly sated.
With the company seemingly treating regulators as a nuisance to be brushed aside, why would a foreign investment limit from the CIRC suddenly stop Anbang in its tracks?
Uncertain Business Model?
Anbang has snapped up market share from rivals by offering the highest returns for its policyholders.
The biggest portion of Anbang’s premium revenues comes from sales of so-called universal insurance policies, a combination of death benefit payout and an annuity with guaranteed payments during a policyholder’s life. Another driver of the company’s recent success is Anbang’s decision to capitalize on the popularity of wealth management products that offer high yields while maintaining short maturities.
None of this is out of the ordinary, as many Chinese insurance companies offer similar products, though few can match the returns promised by Anbang. What’s strange is Anbang’s investment model, which deviates from most insurers.
Insurance companies typically buy into low risk, highly liquid financial securities such as government bonds and investment grade corporate debt. The reason for this is twofold—insurance companies’ No. 1 mandate above all else is to preserve their capital (which is the definition of “to insure”), and since payouts caused by deaths and natural disasters are unpredictable, fixed-income instruments such as bonds offer a stable and secure cash flow over time to cover such liabilities. In effect, a big challenge for any insurer is cash-flow matching, which is having the liquidity profile to cover payouts (cash outflows) with cash inflows generated from investments.
But Anbang completely upends this model. Its assets are real—banks, hotels, and companies—and long term investments. While they generate far higher returns than bonds, they are illiquid and unstable.
Of course, Anbang may have little choice but to swing for the fences. Its policyholders have to get paid, as wealth management products average 7 percent yields, and it must pay its brokers. Its tangled web of owners registered across China also demand returns on equity.
Anbang’s Starwood exit could be a matter of industry regulators putting the brakes on Anbang’s policyholder-financed spending spree. Or it could be Chinese Communist Party politics, as some of its executives were former party officials. Given the meteoric rise, it’s clear Anbang enjoyed past support from Beijing at each step of the way.
But such support could prove fleeting, depending on which side of the Xi Jinping fence Anbang’s executives reside.
More clarity will come soon enough, when we find out how quickly and effectively Anbang is able to deploy its “1 trillion yuan” of capital going forward.
MORE:Chinese Insurer Anbang Walks Away From Starwood DealAnbang Firms Up Its Offer for Starwood

Read the full article here

NEWS ANALYSIS
It’s no hyperbole to call managing China’s economic policy a high-wire balancing act.
After dabbling with letting companies fail last year, Beijing recently announced that the official policy to reform state-owned enterprises (SOEs) going forward will be mergers and acquisitions. China will rule out drastic changes and a “wave of layoffs” to focus on reorganization and consolidation instead, said Xiao Yaqing, head of China’s State-owned Assets Supervision and Administration Commission (SASAC) at a conference on March 12.
Last year, the SASAC presided over consolidation of several large state firms in the strategically important telecommunications, energy, and transportation sectors. Xiao claimed that as a “success” and more of the same will come in 2016.
While preserving jobs is a noble goal, such perfunctory reform likely doesn’t go far enough to solve fundamental problems plaguing the state sector.
Competing Agendas
The Chinese economy—with its reliance on manufacturing and traditional industry—is sputtering. Reforming the dominant state sector is a key first step in Beijing’s plan to diversify into a services and consumption-driven economy.
JPMorgan estimates that China’s 150,000 SOEs employ 17 percent of urban residents, and account for 22 percent of its industrial income and 38 percent of industrial assets. They also make up a vast majority of China’s ballooning corporate debt.
The economic backdrop calls for intervention. The country’s manufacturing sector weakened sharply in January and February due to overcapacity and anemic global demand. Both the official state and Caixin/Markit private manufacturing purchasing managers index (PMI) fell in February. The Caixin/Markit reading of 48 shows the country’s manufacturing sector is squarely in contraction territory, where it has remained in the last twelve months.
MORE:China Bets on Entrepreneurship to Boost Jobs
But for China, economic policy is always intertwined with politics. The No. 1 mandate for Chinese Communist Party is self-preservation, and massive layoffs and deep structural changes are bad politics. The social and political fallout from the type of SOE restructuring required is something the Party cannot stomach.
Head-Scratcher
Former premier Zhu Rongji enacted the first round of SOE reform in the 1990s. Bloomberg estimated that Zhu shut 60,000 companies and eliminated around 40 million jobs. The reform was deep, painful, but ultimately successful in helping to launch China’s subsequent economy growth.
Today, China has ambitious plans for its SOEs. State companies must transfer 30 percent of their profits to the central government by 2020—up from the 15 percent or less requirement today. By 2025, China hopes these SOEs will be profitable enough to go public.
Officially, Beijing is earmarking much of the cash to fund retirement and healthcare costs for an aging population, but most likely, the funds will go to defense spending, espionage, and security/monitoring of its residents.
Against this backdrop, SASAC’s plan of SOE reform is a head-scratcher.
Consolidating SOEs into bigger ones will minimize job losses in the short term. But in the long term, it will worsen the structural problems inherent in a dominant state sector.
In fact, merging and consolidating the state sector could prevent Beijing from achieving its lofty goals. Slow, lumbering SOEs will become even slower and more lumbering. Bureaucracy and red tape will increase, and decision making process will suffer. Also, the size, scale, and bias of large government owned companies could dwarf and decimate smaller, private rivals and put them out of business—hampering the private sector growth that Beijing wishes to cultivate.
More importantly, consolidation doesn’t solve the fundamental issue of inefficiency and overcapacity.
The Hebei Experiment
For proof, China needs to look no further than Heibei Province, which is right outside the walls of Beijing.
In 2008, the government of Hebei province merged two major state-owned steelmakers to form Hebei Iron and Steel Group. It acquired more companies since, to become China’s biggest steel producer.
For the third quarter 2015, operating income at Hebei Iron and Steel fell 24.9 percent from the year prior and 19 percent from the previous quarter. Such losses have been trending over the last several quarters. It’s also mired in debt—as of Sept. 30, 2015, the company’s short and long-term debts are 55 percent of its gross assets.
MORE:China to Accelerate Steel Dumping in 2016
Simply put, Hebei Iron and Steel, a behemoth formed after rounds of mergers, is performing even worse than before.
And there’s little relief in sight. Crude-steel production for the first two months of 2016 dropped 5.7 percent from a year earlier, according to official data from China’s statistics bureau released March 12. Total steel-related production output fell 2.1 percent to 162.28 million metric tons.
One can argue that Hebei Iron and Steel offers anecdotal evidence, as the steel industry has been mired in a global slump for years. But many of China’s SOEs in the banking, shipping, and consumer-goods manufacturing sectors face similarly distressed outlooks. It’s hard to envision that after consolidation, such companies can compete with nimbler rivals on the international stage.
The province couldn’t consolidate its way into the future. Hebei, which lies in China’s northern rust belt and produces about a quarter of China’s steel output, has decided its only recourse is to trim capacity and close plants. Chinese business journal Caixin reported March 9 that Hebei plans to shut down more than half of its steel plants—240 out of 400—within the province by 2020.
The final toll? One million workers will be laid off in the next two years.

Read the full article here

NEWS ANALYSIS
It’s no hyperbole to call managing China’s economic policy a high-wire balancing act.
After dabbling with letting companies fail last year, Beijing recently announced that the official policy to reform state-owned enterprises (SOEs) going forward will be mergers and acquisitions. China will rule out drastic changes and a “wave of layoffs” to focus on reorganization and consolidation instead, said Xiao Yaqing, head of China’s State-owned Assets Supervision and Administration Commission (SASAC) at a conference on March 12.
Last year, the SASAC presided over consolidation of several large state firms in the strategically important telecommunications, energy, and transportation sectors. Xiao claimed that as a “success” and more of the same will come in 2016.
While preserving jobs is a noble goal, such perfunctory reform likely doesn’t go far enough to solve fundamental problems plaguing the state sector.
Competing Agendas
The Chinese economy—with its reliance on manufacturing and traditional industry—is sputtering. Reforming the dominant state sector is a key first step in Beijing’s plan to diversify into a services and consumption-driven economy.
JPMorgan estimates that China’s 150,000 SOEs employ 17 percent of urban residents, and account for 22 percent of its industrial income and 38 percent of industrial assets. They also make up a vast majority of China’s ballooning corporate debt.
The economic backdrop calls for intervention. The country’s manufacturing sector weakened sharply in January and February due to overcapacity and anemic global demand. Both the official state and Caixin/Markit private manufacturing purchasing managers index (PMI) fell in February. The Caixin/Markit reading of 48 shows the country’s manufacturing sector is squarely in contraction territory, where it has remained in the last twelve months.
MORE:China Bets on Entrepreneurship to Boost Jobs
But for China, economic policy is always intertwined with politics. The No. 1 mandate for Chinese Communist Party is self-preservation, and massive layoffs and deep structural changes are bad politics. The social and political fallout from the type of SOE restructuring required is something the Party cannot stomach.
Head-Scratcher
Former premier Zhu Rongji enacted the first round of SOE reform in the 1990s. Bloomberg estimated that Zhu shut 60,000 companies and eliminated around 40 million jobs. The reform was deep, painful, but ultimately successful in helping to launch China’s subsequent economy growth.
Today, China has ambitious plans for its SOEs. State companies must transfer 30 percent of their profits to the central government by 2020—up from the 15 percent or less requirement today. By 2025, China hopes these SOEs will be profitable enough to go public.
Officially, Beijing is earmarking much of the cash to fund retirement and healthcare costs for an aging population, but most likely, the funds will go to defense spending, espionage, and security/monitoring of its residents.
Against this backdrop, SASAC’s plan of SOE reform is a head-scratcher.
Consolidating SOEs into bigger ones will minimize job losses in the short term. But in the long term, it will worsen the structural problems inherent in a dominant state sector.
In fact, merging and consolidating the state sector could prevent Beijing from achieving its lofty goals. Slow, lumbering SOEs will become even slower and more lumbering. Bureaucracy and red tape will increase, and decision making process will suffer. Also, the size, scale, and bias of large government owned companies could dwarf and decimate smaller, private rivals and put them out of business—hampering the private sector growth that Beijing wishes to cultivate.
More importantly, consolidation doesn’t solve the fundamental issue of inefficiency and overcapacity.
The Hebei Experiment
For proof, China needs to look no further than Heibei Province, which is right outside the walls of Beijing.
In 2008, the government of Hebei province merged two major state-owned steelmakers to form Hebei Iron and Steel Group. It acquired more companies since, to become China’s biggest steel producer.
For the third quarter 2015, operating income at Hebei Iron and Steel fell 24.9 percent from the year prior and 19 percent from the previous quarter. Such losses have been trending over the last several quarters. It’s also mired in debt—as of Sept. 30, 2015, the company’s short and long-term debts are 55 percent of its gross assets.
MORE:China to Accelerate Steel Dumping in 2016
Simply put, Hebei Iron and Steel, a behemoth formed after rounds of mergers, is performing even worse than before.
And there’s little relief in sight. Crude-steel production for the first two months of 2016 dropped 5.7 percent from a year earlier, according to official data from China’s statistics bureau released March 12. Total steel-related production output fell 2.1 percent to 162.28 million metric tons.
One can argue that Hebei Iron and Steel offers anecdotal evidence, as the steel industry has been mired in a global slump for years. But many of China’s SOEs in the banking, shipping, and consumer-goods manufacturing sectors face similarly distressed outlooks. It’s hard to envision that after consolidation, such companies can compete with nimbler rivals on the international stage.
The province couldn’t consolidate its way into the future. Hebei, which lies in China’s northern rust belt and produces about a quarter of China’s steel output, has decided its only recourse is to trim capacity and close plants. Chinese business journal Caixin reported March 9 that Hebei plans to shut down more than half of its steel plants—240 out of 400—within the province by 2020.
The final toll? One million workers will be laid off in the next two years.

Read the full article here