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Banks Face Chinese Resistance over Derivatives Losses

September 8, 2009

The South China Morning Post published an article today that has caused quite a stir.  It seems that Beijing and global investment banks are involved in a dispute over significant losses China’s state-owned airlines have suffered on oil futures contracts.

The central government and foreign banks are threatening legal action against each other in an escalating row over ballooning losses racked up by state-owned airlines which ran into the red on derivatives contracts.

Air China (SEHK: 0753, announcements, news) , China Eastern (SEHK: 0670) and Shanghai Airlines have reported losses of almost US$2 billion since last year on aviation fuel-hedging contracts after taking wrong-way bets on oil prices with their banks.

The article names Citi, Goldman Sachs, JPMorgan, and Morgan Stanley as banks that regularly sell derivates to mainland companies.  It notes that the banks face a serious dilemma:

While the commission is threatening legal action, banks are more worried about ruining relations with Beijing and losing access to lucrative mainland banking licences. The banks must balance this by not being seen to roll over, inviting a flood of refund claims from firms whose own derivative bets went the wrong way.

I’m not at liberty to discuss other specific situations I’ve heard about in private business discussions.  But I do think it’s fair to say that this is not an isolated case.  A report by Caijing last week stated that:

China’s state-owned enterprises may unilaterally terminate commodities contracts as they try to cut massive losses from financial derivatives 

In the wake of the global financial crisis, many people commented that China’s less sophisticated financial system had benefited from its lack of exposure to the complex derivatives that wreaked such havoc in the U.S. and Europe.  This was certainly true of mortgage-backed securities.  But over the past few years, a number of Chinese companies have taken active “hedging” positions in relation to commodities and foreign exchange.  Caijing‘s source indicated the capital involved in these trades could exceed RMB 1 trillion (USD 146 billion).  Of course, gains or losses in derivatives trading can far exceed the capital invested.

The extent of any losses Chinese SOEs may have incurred, due to high volatility in these markets, is unclear.  How these losses will be resolved between the banks and Beijing remains to be seen.  It would also be interested to know whether any of the banks’ corresponding gains have been recognized or not, and what kind of impact any refund would have on their latest financial statements.

Full Disclosure: An immediate family member is employed by Morgan Stanley.  No confidential information is contained in this post, and I have no direct knowledge of the situation in question.

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