In China, Neither Side Wants Derivatives Confrontation

A number of reports in late summer said China’s State-owned Assets Supervision and Administration was giving its tacit sanction to Chinese companies to back out of loss-making derivatives positions. However, a recent Reuters story (Sept. 29) suggests  that both sides will aim to head off litigation or even arbitration. On the one hand, Chinese authorities recognize that hedging tools are necessary. On the other, the foreign investment banks who were the counterparties to the deals would prefer to avoid a confrontation that might endanger a promising market.

In late 2008 and early 2007 a number of Chinese State-Owned Enterprises (SOEs), especially in the energy sector, suffered large losses from poorly constructed commodity hedges. Over the summer reports began circulating that the relevant Chinese regulator, the State-owned Assets Supervision and Administration Commission (SASAC), was pressuring the foreign counterparties to cancel the losses—in other words, to allow the Chinese customers to default. A recent Reuters story (Sept 29) suggests that both sides may seek a resolution that would both avoid further damaging China’s reputation as a fair place to do business while reducing the damage to the artless hedgers.

At the heart of the problem were over-the-counter derivatives positions that may have contained a hedging element, but also had speculative features triggered by scenarios that were considered unlikely. For example, CITIC Pacific, one of China’s biggest SOEs, lost over $2 billion in foreign exchange positions, while China’s three largest airlines, Air China, China Eastern, and Shanghai Air, collectively lost $1.94 billion in poorly constructed energy hedges.

Although details of the most of the deals haven’t generally been disclosed, the structure of one of them reported in the Wall Street Journal in December In one contract dated March 1, a Chinese oil company agreed to receive a monthly payment of $300,000 from a major investment bank so long as oil prices stayed above $63.50 a barrel. But when oil prices fell below $62, the company was on the hook to pay the bank the difference, multiplied by 400,000 barrels. In other words, the gains and losses were not symmetrical—losses multiplied quickly if prices fell below $62, which they did. Now why would the company enter into such a seemingly lopsided contract? The answer is that the price of oil was over $100 when the deal was struck. Along with almost everyone else, the Chinese firm doubtless assumed the likelihood of a further rise in prices was much greater than that of a decline. By accepting potentially larger losses in the event of a big decline, the firm was able to lower the cost of the “hedge.” As it discovered, along with a number of its peers, terms that lower costs have a price. In derivatives jargon, what the firm had done was “sold puts” against long calls.

The widespread perception in China is that the Chinese firms didn’t really understand the structures that they bought and that the sophisticated banks took advantage of their naiveté. In any event, China’s SASAC has issued new guidelines for Chinese would-be hedgers stipulating that they enter into derivatives positions only for hedging purposes. The trouble is, how to define a hedge, and when a hedge begins to take on a speculative element, can be a matter of interpretation. The buyers of the hedge may be eager to consider a structure a hedge if it appears to lower their hedging cost by discounting the likelihood of an adverse move in prices—as happened in the above example.

These cases are by no means unique—similar “hedges” gone bad have happened before, not only in China but in just about every market. What these cases do illustrate, however, is the importance for a company not only to have a well thought-out risk management policy, but the administrative structures in place to ensure that the measures are followed.  Back in 2005 China Aviation Oil (CAO), a Singapore subsidiary of a Chinese State-Owned Enterprise, lost $550 million from speculative losses that wiped out the firm’s capital.  An independent audit by PriceWaterhouseCoopers revealed that CAO had a stat-of-the-art risk management policy. The problem was, the policy guidelines had been completely ignored.

It appears that the Chinese authorities now seek a resolution that would give some relief to the hapless hedgers without doing irreparable harm to confidence of the marketplace in China as a place to do business. Complaints about lack of transparency in laws and regulations are common, and China’s authorities recognize that development of the economy and financial sector in particular depend on reasonably consistent and transparent ground rules. It’s not easy to have it both ways, and the regulators may have a tricky needle to thread.