China warns of OTC default

SAINT

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An interesting article last week in Reuters about Chinese state-owned enterprises warning six foreign banks that they may walk away from OTC hedge contracts if they are loss making.

It's rumoured that China was lured, or is not happy with the outcome of it's large OTC puts in silver and possibly gold, which would mean that China dumping the U.S. dollar and going into gold/silver would see a big loss on the puts. Almost a get out of jail card for the U.S. currency.

Walking away from these contracts would threaten big losses to the counterparty and put the U.S. dollar at risk.

One article references a large short postiotion in comex silver which represents 25% of world production. This position was held by AIG, Bear, and now JP Morgan.
 
GIVEN its vast reserves and seemingly healthy economy, a default by China’s government or one of its tentacles should be one of the lesser concerns for international markets. This perception was jolted on August 28th by reports that the State-owned Assets Supervision and Administration Commission (SASAC) might endorse a move by large state-controlled enterprises under its umbrella to break derivatives contracts that were purchased last year from international banks to protect them from rising commodity prices.

Details, inevitably, are fuzzy. There is no official comment; terrified international bankers are silent. But reports in the local press and some elaboration by participants suggest that efforts by the country’s large shippers, airlines and power companies to cope with high oil prices by taking out futures contracts produced steep losses as the market reversed and prices fell.

That apparently prompted SASAC to launch an investigation, in part to find out if its wards were engaged in outright speculation, rather than hedging, but also to determine if a bail-out could be arranged. The bluntest remedy would be to break the contracts entirely; another, to force contracts to be rewritten and losses reduced. Either outcome would be costly for the foreign banks, in the short run through lost profits and in the long run because a growing business in derivatives would be badly undermined.

For China, too, the consequences would hurt. Counterparties would presumably charge more in future to offset the risk of being stiffed. There would be legal fallout as well. If the contracts were arranged outside China through subsidiaries in Hong Kong, Singapore or London, which is common, then they were almost certainly done under non-Chinese laws that are unlikely to be sympathetic to deliberate deadbeats. Given the direct ties these companies have to the state, a default could in theory trigger a sovereign credit failure and the legitimate seizure of state-owned assets (though it is a stretch to believe that any bank with interests in China would push a case that far). If the contracts were arranged inside China, the companies might claim to have lacked the authority to have engaged in them, but that would undermine their ability to do business abroad.

One theory is that Beijing is trying to squeeze foreign banks out of the derivatives business. That would accord with rules recently put into effect that restrict the ability of foreign firms to develop derivatives. China, it is said, would like its own banks to gain expertise and, if profits must be made, have them benefit. If so, independent pricing of risk, which is what derivatives are meant to be about, would be the real casualty.

published in economist 3rd sept
 
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