CHINA TALKS TOUGH ON FOREIGN BANK DERIVATIVES / THE FINANCIAL TIMES

China talks tough on foreign bank derivatives

By Sundeep Tucker and Robert Cookson in Hong Kong

Published: September 14 2009 19:23

Foreign banks have made relatively few inroads in China since the start of the decade when the country’s financial markets were clawed open by global trade agreements.

Overseas banks’ market share of loans, retail deposits and trading of domestic securities remains painfully low, dwarfed by powerful local competitors.

Among the few lucrative calling cards used by western bankers in China has been their perceived expertise in structured derivatives, and how these could assist mainland enterprises manage exposure to swings in oil prices, interest rates and currencies.

However, foreign banks now face the prospect of vastly reduced profits from derivative contracts in China after many state-owned enterprises racked up huge losses on the trades, prompting a government body last week to roar its disapproval.

The State-owned Assets Supervision and Administration of the State Council (Sasac) declared its support for legal efforts by some state-backed Chinese companies to break loss-making contracts with foreign banks.

Sasac said it was investigating a number of derivatives deals and would help companies find ways to “minimise losses”.

“Stiffing the foreigners in pursuit of domestic policy goals is a time-honoured practice here,” says Arthur Kroeber at Dragonomics, a research company in Beijing.

“My suspicion is there might be some selective contract abrogation, combined with some penalties for the domestic players to prevent recurrence of the problems in future.”

The issue has climbed the political agenda this year after a number of high-profile cases in which derivatives contracts went spectacularly wrong.

Citic Pacific, the Hong Kong-listed arm of China’s largest investment conglomerate, reported its first annual loss in March after bets against the Australian dollar last year cost it $1.9bn.

Air China lost $1.1bn on oil price bets last year, accounting for 80 per cent of its total loss in 2008.

Sasac’s comments have sparked an all too familiar guessing game among bankers in Beijing and Hong Kong: just how muscular does China plan to be? And if contracts are abrogated, how should western banks respond?

Most global investment banks have been involved in the selling or structuring of these derivative trades and remain cautious about airing their views on the matter.

Privately leading bankers rate it unlikely that contracts will be torn up.

Some speculate that the political jockeying has been spurred by senior Sasac officials keen to enhance their nationalist credentials ahead of the next round of government promotions.

In the event of a default, a global bank would have little choice but to go to court in London or Singapore, where most of these contracts are governed, even though any victory could prove pyrrhic.

“Assuming that the Chinese company loses in court, enforcement would be an issue,” says one senior executive of a global investment bank based in Hong Kong.

“No foreigner could take and sell an airline’s assets, so China’s sovereign rating would end up being downgraded.”

The banks usually acted as brokers and “offset” the trades with counter-parties, including hedge funds and other financial institutions. Unwinding those trades if a Chinese company defaulted on a contract would result in heavy financial and reputational losses.

“I think most contracts will be honoured,” says Andy Xie, an independent economist based in Shanghai. “This is about [the implications for] the future.”

Mr Xie says actions taken this year by Sasac and other government bodies have already made selling derivatives in China much more difficult for foreign banks, and would cut off a major source of profits.

The heavy betting is that Sasac’s most recent move is a shot across the bow of western banks, some of whose trades it perceives to have been sold by aggressive salesman who did not sufficiently explain the risks.

Sasac wants state-owned companies to be far more cautious about the trades they sign up to and has already taken measures to ensure derivatives are only used for hedging, rather than speculation.

Many people have little sympathy with the companies’ predicament. “Chinese companies are repeat offenders,” notes Satyajit Das, author of Traders, Guns and Money.

“To paraphrase Mark Twain, Chinese derivative problems not only repeat but it sure looks like they rhyme.” However, western banks have not escaped with their reputations untarnished.

Mushtaq Kapasi, a lawyer who spent years helping create exotic derivatives for investment banks in Hong Kong, wrote a commentary this spring in the Chinese business magazine Caijing, describing how foreign banks sold derivatives that were more complex and risky than necessary to boost their profit margins.

“No one forced companies to buy these derivatives or accept the contracts the banks wrote. But the banks always knew more than the companies, and they exploited this advantage,” he wrote.

Chinese banks are regarded by some commentators as lacking expertise and risk appetite for structuring derivatives.

Analysts believe that mainland companies will have to continue dealing with western banks to hedge their exposure to commodities such as oil.

But doing so could become more expensive if the risk of government intervention in the market continues to rise.

“The announcements this week can only introduce uncertainty,” says Paul Browne of law firm Simmons & Simmons in Hong Kong.

“And that is not helpful for the market.”

Copyright The Financial Times Limited 2009