International | Sep 02 2009
By Greg Peel
In the lead up to the Crash of ’87, the Hong Kong stock market was booming along with every other stock market. This was an opportunity not lost on to the local controlling Chinese families in Hong Kong, who dived not only headlong into the stock market but also into a futures contract listed over the Hang Seng index by a fledgling Hong Kong Futures Exchange. So insatiable was the Chinese appetite for these new-fangled index investments that demand pushed the futures into a steep premium over the level of the underlying physical index.
An opportunity was thus presented to experienced, foreign, derivatives trading investment banks. By shorting the futures contract (which requires no borrowing) and buying a replicating basket of Hang Seng 225 stocks on the stock exchange, foreign investment banks had built up extensive, low risk futures arbitrage positions – long stock, short futures at a big premium, little market risk.
When stock markets crashed in October ’87 the Hang Seng was also a victim, and a panicked Hong Kong Stock Exchange closed its doors for four days. When finally it reopened, the HKFE contract had fallen into a deep discount against the physical. The foreign investment banks were looking at profits in the millions. All they had to do was sell their stocks and buy back their futures contracts. The first leg was no problem, but then they ran into trouble on the second leg.
Having lost millions on both stocks and index contracts, the Hong Kong ruling families simply decided to walk away. They couldn’t walk away from stock losses but given insufficient legislation they were able to get away with simply reneging on their futures positions. There was no government intervention. The foreign banks were thus stuck with a “leg in the air”. They had lost millions on their long stock positions with no cover from their short futures positions.
That was the Chinese way.
Over twenty years on, and the Chinese have still not learnt very much about how financial markets work in a capitalist world. The average Chinese still treats the stock market like a casino, and after decades of communist rulers ensuring a Great and Mighty China (as far as the populace was led to believe) the average Chinese expects the government will not let the stock market crash. Having corrected by 20% lately, investors have called for, and expected, government intervention on the Shanghai stock exchange. Not because there is an anniversary celebration coming up, but because that’s what is simply expected. Otherwise China might “lose face”, notwithstanding individuals losing money.
In the last decade, China has received a crash course (no pun intended) on more complex trades than just buying futures contracts. State-owned companies have learned how to hedge losses in commodity and foreign exchange markets by entering into derivatives market positions. The nature of a “hedge” is that you must always lose on one side of your position, as either the underlying market will run against you, providing an offsetting profit on your hedge, or it will run for you, providing an offsetting loss on your hedge. The idea is that at least you know where you stand on a net basis.
Apparently Chinese state-owned enterprises (SOEs) have recently become big commodity and forex hedgers, given the extraordinary volatility in commodity prices and currencies over the last year. It is clear those hedge positions were put in place to offset a fall in commodity prices and a rally in the US dollar, because since November the opposite has been true, and some SOEs are staring at huge losses on hedge positions. According to the New York Times, Citic Pacific (one third owned by the SOE China International Trust and Investment Company), for example, was sitting on currency hedging losses of US$2bn as at December, while by January three state-owned airlines had collectively lost a similar amount on oil price hedging.
China’s SOEs are regulated by the State Assets Supervision and Administration Commission (SASAC). Over the weekend a Chinese financial magazine – Caijing – reported that a letter had been sent by SASAC to SOEs. That letter suggested the SOEs may unilaterally terminate derivative contracts with six foreign banks that provide over-the-counter commodity hedging services. In other words the SOEs could keep their underlying gains and simply renege on their losses, with government support.
It could be Hong Kong ’87 all over again.
There has nevertheless been no confirmation such a letter exists, and SASAC has declined to comment. Foreign China-observers doubt its existence. However, what is known is that the Chinese government has held grave concerns over its SOEs’ inexperienced derivatives market forays. The NYT notes a report from the state-owned Shanghai Securities News early in August that the government planned to tighten the rules on OTC derivatives trading.
In the same week, the NYT reports, the China Business News cited an unidentified source as suggesting Chinese banks and businesses trading in financial derivatives would be more heavily regulated, that speculation would be discouraged, and that derivatives trading with foreign institutions would be flat out banned.
That is also the way with China – two steps forward into the brave new capitalist world, a shock, and then one step back.
While the SASAC letter may well prove to be a rumour and no more, such rumours do little to engender foreign faith in financial dealings with a culturally divergent counterparty. China and other emerging markets are held up as the Great Hope for economic recovery from the GFC – real economic recovery that is – and many a foreign investor is putting great stake in emerging market investment. Such rumours are enough to scare such investors right away.
