The unprecedented sanctions on Russia are prompting investors to question whether the U.S. could ever bring similar measures against Chinese banks. The queries come amid a steady intensification of the strategic confrontation between the U.S. and China. S&P Global Ratings believes severe sanctions would likely send into default those Chinese financial institutions with outstanding dollar debt. Further, current bond document language does not protect investors against this outcome.

Because the dollar dominates in global trade and reserve holdings, multinational entities pay close attention to U.S. legal developments. This is particularly true for global financial institutions. The U.S. accounts for around a quarter of the world's GDP, and the dollar accounted for about 60% of foreign-exchange reserves at end-2021, globally. Moreover, international financial institutions could be subject to heavy fines and other penalties if found to be noncompliant.

While such sanctions as highly unlikely, the effects could be severe and bear discussing.

Frequently Asked Questions

What signals are investors responding to when asking about sanction risks?

Chinese regulators are introducing measures to manage sanctions. This suggests to some the risk is real, if remote. In late May, the China Banking and Insurance Regulatory Commission (CBIRC) advised institutions to not implement foreign legal restrictions. It advised further that entities should adhere to China's Anti-Foreign Sanctions Law.

Also in May, the Hong Kong Monetary Authority said it was making preparations to mitigate the risk of the removal of Hong Kong banks from the international financial messaging system SWIFT, according to press reports. The regulator was also taking steps to manage a potential freezing of central bank and commercial bank assets. The authority was preparing for an extreme event, given Hong Kong's heavy integration into the global financial system. This includes management of the Hong Kong dollar, which has been pegged to the U.S. currency for almost 40 years.

The Anti-Foreign Sanctions Law has been implemented in mainland China since June 2021 but not yet in Hong Kong.

Many investors cite the West's sanctions on Russia, including cutting Russian banks from the SWIFT system, as a sign that similar measures could be applied against Chinese financial institutions.

How might sanctions hit Chinese financial institutions?

In most ways that matter, including likely defaults. Sanctions could hurt a financial institution's reputation, investor confidence, client relationships, financials, funding, and liquidity. This could spill over to counterparties such as borrowers, investors, and depositors.

In our view, a financial institution's scope of business would determine the effects of sanctions. The consequences would be more severe if a commercial bank has broad business lines and a wide international footprint.

In a severe-impact scenario, we anticipate direct and secondary sanctions would prevent Chinese financial institutions from making payments or transfers, and from doing all foreign exchange, when dollars are involved. These activities are central to international financial institutions.

Cutting sanctioned financial institutions from such essential functions could lead to their technical default, irrespective of liquidity and other financial buffers on hand (see "What Is The U.S. Sanction Risk For Banks Operating In Hong Kong?" published Sept. 17, 2020, on RatingsDirect).

The international financial system is complex and interconnected. Multiple financial intermediaries are involved in payment processes. These service providers may erect transactional barriers and stop the fulfilment of existing agency arrangements, citing legal concerns. These could ultimately lead to nonpayment of an obligation by a financial institution, even if the entity is willing and otherwise financially able to make the payment.

If an issuer can't make a payment because it is subject to sanctions, then we would lower the rating on the debt to 'D', in accordance with the terms. This also applies when the issuer transfers funds to a paying agent on time, but sanctions or a judicial order prevent payment of those funds to investors.

Is there a way around it?

Not really. If sanctions were imposed on a financial institution such that it was unable to access U.S. dollars, we would assess other means it might use to meet its U.S. dollar obligations.

The first thing we would consider is whether the terms of the obligation allowed for payment in a different currency, different place, or in a different manner. If the issuer made the payment in accordance with flexibility allowed under the original terms, then the obligation would not be in default, assuming that our timeliness standard is met (see "How Our Definition Of Default Takes Account Of Sanctions And Other Types Of Payment Restrictions," April 15, 2022).

However, our analysis of 170 offer circulars of U.S. dollar bonds of Chinese financial institutions issued since Jan. 1, 2019, show no instance of an alternative arrangement to pay in a different currency. While program summaries mention potential payments in other currencies, these are subject to applicable legal and regulatory requirements and lack implementation clarity, especially under our severe scenario.

This means that, should U.S. dollar restrictions be imposed under a severe-sanctions scenario, the relevant issuers would have to restructure the debt to change the payment currency, or likely face a default.

Restructuring debt to change the payment currency takes time and could still result in default if an agreement did not meet our timeliness standards. If an agreement were reached, we would see this as an exchange offer and still consider the nature of the modification and the value of the agreed repayment. This could still result in default if the restructured value is less than the original promise, and the deal was agreed under a distressed situation, in our view.

Based on our data sample, a modification to the payment currency--if requested--is typically covered by the standard procedures to change contractual terms. This typically requires consent from a super-majority of bondholders.

What about currency indemnity clauses?

This is not an alternative currency clause. In other words, while these clauses are common, they do not cover standard repayments of the bonds. It typically applies to using another currency for filing claims, which describes a recovery situation after a bond default. It also applies to obtaining and enforcing orders and judgments.

Furthermore, the indemnity constitutes separate and independent obligations of the issuer and does not discharge the original bond liability. As such, these clauses are not useful in managing currency unavailability risk, in our view.

Can terms be easily updated to mitigate currency unavailability risk?

No. While it may make sense for investors to request alternative currencies for repayment, the mechanisms by which this would occur could be subject to regulatory scrutiny. For instance, participating parties could be seen as assisting the evasion or avoidance of sanctions, and be penalized accordingly.

This complication can be difficult to navigate. In late May, Chinese regulators reminded domestic entities to not implement foreign legal restrictions. The National Security Law in Hong Kong also complicates matters for some multinational financial institutions. These institutions may face significant challenges in implementing foreign measures while complying with domestic rules for their businesses.

Where is investor focus turning now?

Investors are flagging currency unavailability risk, or the risk an institution could be cut out of the dollar system. While the likelihood of this happening is very low, the consequences are high if severe sanctions result in defaults by financial institutions. This is an operational risk scenario, and one not likely mitigated by high capital and liquidity buffers.

Resolving these risks for investors is complicated, especially when different rules from different jurisdictions apply. Multinational institutions could also face significant challenges in implementing rules for their businesses should these events unfold. It is good to be prepared, but in this instance, it could be in the "too hard" basket for a while yet.

Editing: Jasper Moiseiwitsch

Related Research

• Credit FAQ: How Our Definition Of Default Takes Account Of Sanctions And Other Types Of Payment Restrictions, April 15, 2022
• Cryptos Won't Blunt The Sting Of Sanctions On Russia, March 4, 2022
• What Is The U.S. Sanction Risk For Banks Operating In Hong Kong? Sept. 17, 2020