China | China - Renege On Derivatives?

1st Sep '09 by doverbeach

4 comments 5652 reads

The rumour: http://english.caijing.com.cn/2009-08-28/110230655.html

China's state-owned enterprises may unilaterally terminate commodities contracts as they try to cut massive losses from financial derivatives, an industry source told Caijing on August 28.

According to the source, China's State-owned Assets Supervision and Administration Commission (SASAC) has sent notice to six foreign financial institutions informing them that several state-owned enterprise will reserve the right to default on commodities contracts signed with those institutions.

Keith Noyes, an official with the International Swaps and Derivatives Association, a trade organization, confirmed that he is aware of the matter, but provided no further comment.

and FTAlphaville's comments on it: http://ftalphaville.ft.com/blog/2009/09/01/69256/chinas-derivative-threat-causes-a-stir/

Now, considering China’s commodity purchases have helped support the global rebound to a large degree this year, there are some important implications not only for the six banks involved in outstanding contracts, but also for all current and prospective counterparties, to say nothing of the health of the global economy in general.

What’s more if the SASAC reneges there’s no telling what sort of precedent that would set for other Chinese companies.
This is not 10 years ago, after all. China has grown to become a critical trading partner for many western institutions, with many respective counterparties clearly under the impression that the days of contract “u-turns” were largely behind the country.

As for the losses themselves, it seems many in the market do believe the sums involved could be pretty substantial.

Shanghai was flat yesterday after dropping 6% on the rumour the day before, with Honk Kong and Singapore following the same pattern.

Reuters on the US commodity market reaction: http://www.reuters.com/article/fundsFundsNews/idUSPEK1183220090831

"Historically, it is not so unusual for China to either renegotiate or abandon some deals that have been made. Some traders who have been around for a while are certainly aware of that possibility," said Bill O'Neill, managing partner at New Jersey-based LOGIC Advisors. ...

"It's a handful of companies who are being encouraged by regulators to renegotiate. It's outrageous, but it's China so everyone is treading very carefully," said a banking source.

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emptyend

1st Sep '09

Its not impossible that this would occur - and it isn't difficult to envisage which banks might be at risk.

It has generally been the view amongst the investment banks for many years now that sovereign-related entities are "fair game" for some fairly exotic transactions - and I would be unsurprised if the contracts that are the subject of this dispute are relatively unusual (and leveraged) structured deals, rather than plain vanilla forwards, swaps etc.

I think of these sort of things as the "big boys' equivalent of mis-selling claims". Certainly there is plenty of precedent for sovereigns applying the big stick to investment banks when they feel (frequently with justification) that they have been legged-over! I can think of at least one case going back to the late 1980s in which Italy forced Morgan Stanley to .....err...... review a derivative deal they had done with them.

So - I'd think that there is every chance that a handful of banks will eat some pretty big losses (quite possibly into the billions) from some exotic deals done with the Chinese .....but I very much doubt there will be any lasting damage whether to the banks, the derivatives markets, the commodities markets or to the Chinese relationships with Westerm banks.

Storm in a teacup, IMO....just an excuse for a bit of profit-taking.

rpcroft

I wonder what they are up to.

Sacrificing their reputation for honouring deals wouldnt be done lightly and would hinder their ability to do business. And if the sums are very large then they would become scapegoats, blamed for the larger fall-out.

Why would they invite such criticism, if there is anything to this then there must be some deep strategic thought behind it. But what?

In reply to rpcroft (post #2)

Simple. The "strategic thought" is to try to stop the banks from taking liberties with the newbie capitalists in corporate China.

2nd Sep '09

More on a related topic today in the Wall Street Journal:

Starting Sept. 16, China will put into effect a new agreement governing how banks trade domestic financial derivative products among themselves. But as a condition of dealing with foreign banks, China's five largest commercial banks are seeking to impose tough credit demands that will be hard to comply with..........

Under the new trading regime, banks will only be allowed to trade with counterparties with whom they have signed a master agreement. That agreement will initially cover existing trading in interest rate swaps, bond forwards, foreign exchange swaps and forwards and cross currency swaps.

But the five big banks are insisting that foreign banks, and in some cases their major shareholders, guarantee the credit of their China units before they sign any agreement, according to foreign bankers with direct knowledge of the situation.....

Under existing arrangements, foreign banks can trade derivatives with those banks without providing credit guarantees.

Since Lehman's demise would undoubtedly have created losses for a range of Chinese counterparties (as they were very big in the region), it is hardly surprising to see this sort of move, IMO.

China - renege on derivatives?

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Doverbeach

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