China Ink

A debacle over derivatives

China’s state firms may choose to default on loss-making derivative contracts. Foreign investment banks are crying foul.

Li Rongrong, the chairman of the Sasac

What was the initial reaction?

Caijing reported that notices had been sent to six foreign financial firms telling them that several state-owned enterprises reserved the right to default on commodities contracts. The notice allegedly came from the State-owned Assets Supervision and Administration Commission (Sasac) – the entity that ultimately controls China’s state firms. The Chinese press reacted favourably. China Business reported that some of the structured products sold to Chinese clients weren’t allowed in the West, and said the executives at the state firms didn’t understand their complexity. Securities Times ran an op-ed piece by a local brokerage firm, CES Capital International which dripped venom and said the incident was further evidence of “how shameless foreign investment banks could be”. A regulator reportedly compared derivatives to ‘financial opium’.

The foreign press was unanimous that the Chinese buyers of derivatives have lost a lot. The worst damage is on commodity derivatives relating to the price of oil, bought when crude was at $130 a barrel. Three of China’s state-owned airlines, for example, have sustained $1.94 billion of losses on fuel hedges, reported the New York Times. Shipping firms were also big losers. But walking away from the deals was viewed as a bad move. The Wall Street Journal noted it was likely to “cause concern in the trading community”. The South China Morning Post said defaults would exact a price: “Foreign banks will be more wary of doing derivatives business on the mainland, which will make it more difficult for China’s state companies to hedge their commodities exposure in the future.”

So not a good precedent?

After they had calmed down, elements of the Chinese media looked at the bigger picture, wondering if all future derivatives contracts should be signed with Sasac and not individual state firms. That doesn’t look workable, although the Shanghai Securities News reported that plans were afoot to tighten rules and stop state firms using over-the-counter derivatives to “speculate”.

The Financial Times declared it a “blow to some of the world’s biggest investment banks”. It reckoned it would kill the derivatives business in China and quoted an analyst who said this was very bad news for US and European banks who make the “lion’s share” of their profits from derivatives deals with state-owned firms.

Has Sasac refined its position?

China Business News finally managed to get Sasac to comment on the Caijing story. But Sasac denied any correspondence with the foreign banks at all, saying that the letter was sent by a state firm. It merely said it was encouraging firms to pursue legal means to reduce their losses.

But Sasac likewise made clear that it was continuing to investigate individual deals. CBN also quoted a source close to a state firm who said evidence has appeared that they were “deceived”.

Sasac looks to be studying whether individual trades are illegal or unenforceable, writes the FT. It quotes a legal expert saying the current strategy is to try and renegotiate the transactions rather than walk away from the contracts.

Another theory from the Economist: “Beijing is trying to squeeze foreign banks out of the derivatives business. China, it is said, would like its own banks to gain expertise, and, if profits must be made, have them benefit.”


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