USD13 Billion worth of China Snowball Derivatives are approaching loss levels as the ongoing route of China’s stock market is pressurising these structured products, threatening to raise market volatility. Indeed, over the years snowballs have attracted China’s wealthy and institutional investors, but a rapid decline in the Chinese stock market is now exposing risks to these derivatives hitting loss-triggering levels. But what exactly are “Snowball” derivatives?

A Snowball product is a structured hybrid derivative which pays a bond-like coupon and consists of additional options on basic financial assets, which include underlying assets such as stocks or stock indexes. The word snowball derives from the fact that coupons can be rolled over and coupon pay-outs rely on the underlying asset trading within a certain range. 

Currently, experts are advising that circa USD4.2 Billion (Yuan30 Billion) of snowballs that are tied to the CSI 1000 Index* are approaching levels that trigger losses at maturity, whilst another circa USD8.4 Billion (Yuan 60 Billion) are between 5 and 10% away from their knock-in** thresholds. This week on Wednesday 15th January, the CSI 1000 index closed at its lowest level since April 2022. 

*The CSI 1000 Stock Index – This index is composed of 1,000 small and liquid stocks of all A-shares, excluding the CSI 800 constituents (follows the 800 largest stocks by free-float market cap and represents large and mid-cap A-share stocks). It reflects the stock price performance of a group of small-cap companies in the Chinese A-share market. 

**Knock Ins – There are two types of knock-in options: down-and-in and up-and-in. The former (currently China’s problem) is triggered if the underlying asset price falls below a certain level and the latter is triggered if the underlying asset price rises to a certain level. 

During the Covid-19 Pandemic, snowballs gained in popularity among the wealthy Chinese and asset managers, with brokers typically offering such grand returns or coupon rates of between 12 and 20%. 

Between February and April 2023, many of the outstanding snowball derivatives were issued, and since then the CSI 1000 has fallen by circa 22%, and for those who bought a one year contract with an 80% knock in last February, if there is no rebound in the market, next month they may be holding some serious losses. 

Despite government efforts to kick-start the stock markets by halving stamp duty on stock trades (August 2023), or their own exchanges launching new blue chip benchmarks where sectors such as chip manufacturing or renewables are granted greater weightings, sadly for snowball holders such small measures have failed to work with many investors now looking elsewhere. Unless the government engages in the type of quantitative easing as seen in the past in Europe, the United Kingdom and the United States, there is little else the government can do to stop the pessimism that is sweeping through the stock markets, signalling losses for many snowball holders.

China, the world’s second largest economy, kicks off 2024 with a much weaker economy, raising doubts about the underlying foundations on which its decades of amazing growth is built. Once China’s draconian Covid-19 pandemic laws were revoked, their leaders expected it would be business as usual for their economy. However, instead of consumers returning to malls, increases in land auctions and home sales, and factories tooling up for increases in demand, foreign firms have pulled money out, factories are facing waning demand, consumers are saving not spending, two of the largest properties companies along others have defaulted on their loans and local government finances are in a complete mess.

Reforms have always been particularly difficult in China, but the leaders are now presented with some tough choices if things are to improve in 2024. However, it has been an inauspicious start as Hong Kong’s flagship, the Hang Seng Index, started 1.5% down on 2^nd January 2024. Mainland China’s CSI 300, which measures the top 300 stocks listed in Shenzhen and Shanghai, also dropped 1.3% and in excess of 43% since its peak in 2021. Both indexes were two of the worst performers in 2023 with a slowdown in production activity, lukewarm consumption, a prolonged property slump and concerns over Beijing’s crackdown on the tech sector.

However it is not all doom and gloom for the Chinese stock markets. Experts say that the trends in the Hang Seng Index are closely related to the number of IPO’s (Initial Public Offerings), and the same experts are predicting that HK$100 Billion (Circa £10 Billion and $7.8 Billion) will be raised in Hong Kong in 2024, just over double of that raised in 2023. A number of analysts have gone on to say that today the risk premium of Chinese stocks has reached a level that, in the past, has led to returns nothing short of spectacular. Indeed, the yield gap between stocks and bonds has now reached circa 5.5% and has rarely been this big, in fact the dividend yield of the stock benchmark has risen above the dividend yield of the long term bond benchmark for the first time since 2005. Adding to this optimism for Chinese stocks in 2024, a well-known emerging markets equity fund in the United States boosted its equity holdings of China and Hong Kong stocks in one of their funds to 33% of its portfolio. This confirmed that, in their view, the relentless selling is just about over and 2024 will be a good year. 

On economic growth, top Chinese officials have pledged to put this at the forefront of their economic plans. However, the hole in this plan is the lack of measures to boost consumer spending, which may end up making it hard to deliver on this statement. The tone for economic development for the following year is usually set at the CEWC (Central Economic Work Conference) which finished on the 9th of December 2023. This closely watched conference announced that policy would focus on “the central task of economic development and the primary task of high quality development”. Analysts have suggested that this conference was more pro-growth than in previous conferences, however they went on to say that potential growth levels of circa 5% would be hard to achieve without stimulus measures directly targeting consumer spending. Indeed, there was a complete silence on increasing household income and consumption support policies, and many analysts agree that weak consumption is a major drag on the economy.

On the deflation front, China has been fighting this for most of 2023 due to weak spending and the property slump, and finally policymakers have indicated that they will address this problem, which up to now, has been studiously ignored. Deflation is not good for the economy as falling prices are a major concern, and companies and consumers may put off investments and purchases anticipating a further fall in prices, which in turn can further slow the economy. Acknowledging this problem a quote from the 2023 CEWC said “Total social financing and money supply should be in line with economic growth and the price target”, which basically refers to the amount of financing needed for the real economy. Analysts noted that this was the first time the Price Target had been alluded to, indicating a more accommodating monetary policy. This suggests there will be interest rate cuts in 2024 acting as a stimulus to the economy. It should be noted that the CPI (Consumer Price Index) fell 0.5% in November 2023, the biggest since the Covid-19 Pandemic, marking an acceleration in the rate of deflation. 

The property market has been a major headache for Chinese policy makers and the economy, with experts advising that property market stabilisation should be very near the top of economic priorities. This is because there are signs that the crisis within the property market is spilling over into the broader economy, including consumer confidence and financial markets. The CEWC confirmed that Chinese policymakers will meet this problem head-on by announcing the importance of resolving risks in “real estate, local government debt, and small and medium sized financial institutions”. They went on to say that the government, with regard to three major areas, will accelerate construction in public infrastructure facilities, affordable housing and urban village redevelopment. The property industry accounts for circa 30% of Chinese Gross Domestic Product (GDP), and the real estate slump has accounted for many of China’s current economic problems. House sales have gone south dramatically with developers’ debt problems spilling over into the shadow banking system*.

*China’s Shadow Banking System – This refers to financing outside of the formal Chinese Banking System and is conservatively estimated by experts to be in the region of USD3 Trillion. Such financing is made by banks through off-balance sheet activities or by non-bank financial institutions such as Chinese Trust firms. These trust companies sell investment products to qualified investors and the funds are used to invest in a wide range of financial assets, plus they are used to lend to property developers and their project companies and to local government financing vehicles who in turn lend to property companies. 

Politically, experts suggest that China’s leaders will look to thaw relations with the United States and Europe, if only for economic purposes. Indeed, President Xi Jinping met with President Joe Biden in San Francisco back in November 2023 and recently met with EU Commission officials in Beijing in an effort to keep the European Union close for trade purposes and to get access to technology. However, any perceived thaw will be down to economic expediency and nothing more. In fact, for the first time President Xi Jinping announced in his New Year speech that the economy is facing troubles in such areas as employment, with many finding it difficult to fund basic needs and enterprises having a tough time. He went on to say that we will consolidate and strengthen the momentum of economic recovery. 

Outside influences may have a direct impact on the Chinese economy in 2024. President Xi’s desire to control or unify Taiwan could put China in direct conflict with the United States. The looming presidential election in Taiwan has three candidates, the Beijing sceptic William Lei (Democratic Progressive Party), the Beijing friendly Hou You-Yi (Kuomintang)  and the third candidate Ko Wen-je who will follow the outgoing president’s approach. Beijing will look at this election as a litmus test for a non-violent unification. The possibility of a second Donald Trump term could end up being a real wild card for China/ United States relations, and could well impact some of China’s geopolitical goals. The preferred candidate for China, according to experts, would be anyone showing weakness towards NATO, Ukraine and Taiwan.

The rhetoric coming out of Beijing is setting the tone for 2024 with their ambition for progress, development and global cooperation (with the United States? We will have to wait and see) focusing on growth, sustainability and innovation, paying particular attention to the property sector. The policymakers are looking to promote long-term prosperity and stability in Hong Kong as a vibrant financial sector, as this is also essential in the rehabilitation of China’s economy. However, the property sector could really make or break China’s economy in 2024. There are many failed real estate projects in China and the crisis has also enveloped the once untouchable real estate developer Country Garden, considered by many to be a safe investment. The real worry for Beijing is a dip in housing prices, as roughly 70% of all Chinese household assets are invested in property. The government has continually fiddled with economic data, which they will have to stop in order to get more outside investment, but whilst official figures show housing prices remaining static, it is estimated that house prices have fallen by 15% in many cities and by circa 30% in Beijing.

If indeed the authorities start releasing proper economic data, and can show a credible effort at solving the property sector crisis, then according to many experts FDI (Foreign Direct Investment) will pick up as will the economy. There are many doom mongers who are saying it will be the same old China, all talk and dodgy economic data, but if those who predict a rise in the stock markets are to be believed, in 2024 China will not only talk the talk but walk the walk as well.