It is a little over six years since Warren Buffett first warned that many of the more exotic financial instruments in circulation could be potential “time bombs” – and around eighteen months since the first wave of derivatives began to detonate.
Last week Brazilian president Luiz Inacio da Silva reminded Gordon Brown that “white people with blue eyes” (presumably he isn’t including Buffett) were at the root of the current financial devastation. And it is true that much of the subsequent damage has centred on Western financial capitals. Contrastingly, countries like Brazil, China and India are using the moral high ground to push hard for more influence at the IMF and World Bank, as well as within the G20.
But at least some of the red ink has washed up on more distant shores. According to Caijing magazine, the results of an initial State-owned Assets Supervision and Administration Commission (SASAC) investigation into state-owned companies derivative exposure point to as much as Rmb20 billion ($2.93 billion) of losses.
Of course, far more has been written off in the US and in Europe – and often by individual financial institutions. But others believe the real losses in China could be much higher. A number of the state groups have yet to be surveyed – the chemical and steel giants, for instance – and many others may well have been trading illicitly. Li Fuan, director of innovation supervision at the China Banking Regulatory Commission (CBRC), has admitted that nearly half of those Chinese firms that traded derivatives abroad have done so without government approval.
Only 31 state-owned enterprises are formally licensed to trade on overseas futures exchanges. Those trading without official sanction would have been doing so through private over-the-counter (OTC) arrangements rather than in marketplaces like London or Chicago. As OTC contract volumes are thought to have been between 5 and 10 times greater than exchange-traded business, any associated losses are likely to be greater too. As far as Caijing is concerned as much as Rmb1 trillion of capital could be at risk.
The Chinese also have experience of derivative debacles of their own making. Less than two months ago Chen Jiulin, former president of China Aviation Oil, a foreign subsidiary of a state-owned jet fuel provider, returned to China after completing a jail term in Singapore for an illegal hedging conviction in 2004.
State-owned securities firm Citic Pacific’s difficulties are more current. It reported losses last year on forward contracts on the Australian dollar of at least $1.9 billion and suffered the indignity of Hong Kong crime bureau raids on its offices last Friday, as an investigation began into the circumstances behind the losses, as well as the reasons for the six-week delay in disclosing them.
Publicly, at least, SASAC preferred to talk less about illegal activity and more of fears that most state-owned companies lack the knowledge and expertise to understand the potential risks from over-aggressive trading. Li at the CBRC also wants to steer state firms back to using derivatives for hedging risk rather than for generating profits. Some of the structured products that the Commission had investigated were “almost no different from gambling,” he says.
So for now the clear up continues. State-owned enterprises have been told to review outstanding contracts and those without authorisation must be settled as soon as possible (it isn’t clear if this means an amnesty is in place for rule-breakers).
In future, no derivative commitments may be entered into without governmental approval, and cannot exceed 90% of the value of the covered spot goods. Positions should be held for no longer than 12 months, or the length of the spot contract, whichever is shorter.
It looks like Beijing’s mandarins are insisting on a back-to-basics campaign. Something with which the Sage of Omaha would heartily agree.
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