The news that several prominent Chinese state-owned enterprises are considering defaulting on loss-making derivatives contracts is further evidence of the return this year of a depressing emerging markets tradition. Sources at foreign banks active in China tell Euromoney that at least six such banks have received letters from SOEs informing them that the companies reserve the right to revisit derivatives contracts sold them by financial institutions.
The contracts, generally hedging products designed to offset movements in currency or commodity prices, are incurring heavy losses for the companies in question. Companies from the transport sector have been among the worst hit, with one bank source telling Euromoney that state-owned airlines were among those hoping to extract themselves from contracts now losing money thanks to volatility in the oil price.
So far there has been posturing but no action: the SOEs sent the letters to the banks in August but no defaults have been reported yet. The recipients of the letters believe that they were sent under pressure from the Chinese regulators, which are keen to avoid the public perception that China’s state-owned champions are being savaged by foreign banks and their derivatives.
There is also an element of sabre-rattling by the foreign banks. They have been briefing the story (off the record) to the media with great enthusiasm, perhaps because there’s little else they can do should the SOEs substantiate their threats. No foreign bank would risk taking a prominent Chinese firm to court over the issue, either in China or in Hong Kong and Singapore where the contracts tend to originate, for fear of getting itself blacklisted from lucrative capital-raising and advisory contracts.
Whether or not the state companies have acted under pressure from the regulators, their actions look somewhat counterproductive. The main effect has been to raise the price of hedging for the entire sector, with some of the more outspoken Chinese business media reporting that hedging costs for these companies that have not threatened default have risen by 10% to 20% as counterparties price in their increased risk.
With the total exposure among the foreign banks involved thought to run to a few hundred million dollars, and no defaults as Euromoney went to press, there is little fear of the latest derivatives problem developing into a full-blown disaster. The situation does, however, exemplify a worrying trend. In India, Standard Chartered Bank is suing a sugar-trading firm that refuses to pay out on an underwater derivatives position. In Korea, local firms have been battling in the courts over claims that foreign banks mis-sold them currency derivatives. Similar instances have been reported in Latin America.
Neither the banks nor corporates emerge from these situations with much credit. The companies claim that they were sold dangerous instruments without having had the risks fully explained. Banks counter that derivatives are legitimate tools for managing risks and that they obtain signed confirmations that their clients understand the potential downside. In the case of the Chinese SOEs, their threatening letters have achieved little more than driving up the cost of hedging for their peers and causing a slowdown in trading.
If Chinese companies wish to avail themselves of the (dangerous when misused) derivatives on offer, it is in their interests as a group for individual firms to take their losses without recourse to the courts.
