Saturday, March 28, 2009

Untangling the Hedging Morass at SOEs

Where to draw the line between hedging and speculation? That's a key question now facing China's state-owned enterprises.

By staff reporters Wen Xiu, Li Qing, Ji Minhua and Justin Wong

(Caijing Magazine)A dark omen in the form of an official statement preceded a March 15 deadline for state-owned enterprises to report their financial derivatives positions to the watchdog State-owned Assets Supervision and Administration Commission (SASAC).

“Companies in the minority have insufficient knowledge about the leverage, complexity and risks involved in financial derivatives,” SASAC declared in February. “They opened investment positions illegally, and their risk management was uncontrolled, leading to a negative impact for state assets and security.”

SASAC based its conclusions on data gathered after it asked SOEs in September to investigate their derivatives trading, and report positions and losses. The survey found derivatives trading losses totaled between 10 billion and 20 billion yuan, although one official who participated in the survey said the losses were likely much higher. A follow-up probe of 20 SOEs in January by the National Audit Office confirmed that red ink spilled far and wide.

What’s known so far is that a host of major SOEs including China Railway Group Ltd., China Eastern Airlines, logistics giant COSCO and securities firm CITIC Pacific lost billions of yuan in derivatives.

So far, neither a single SOE nor any of their executives have been penalized for these losses. Trouble may come later. “The issue is still under investigation,” said one SASAC official.

Nevertheless, regulators so far have not been able to drawn a clear line between illegal speculation and improper hedging. Moreover, they haven’t decided whether the losses stemmed from a declining market or an irresponsible lack of risk management.

Beyond these issues and obvious frustrations over losses are questions about SOE investing behavior. Are derivatives products worthy for hedging risks, some wonder, or mere tools of speculation? Is there a clear way to determine whether hedging is in synch with a company’s needs? And are complex structured investment products beneficial, as some argue, or useless?

Going Deeper

The losses disclosed so far are merely the tip of the iceberg. Some derivatives trading transactions have not appeared in reports by listed companies within SOE groups. The state’s chemical and steel giants, for example, have yet to report their positions.

According to a company manager who refused to be named, almost all SOEs tied to import-export business are engaged in derivatives trading. And the number of companies is far higher than the 31 formally licensed for overseas futures exchanges. As much as 1 trillion yuan in combined capital could be involved in derivatives trading.

Among those that openly reported losses is CITIC Pacific, a state-owned securities firm that bought leveraged foreign exchange forward contracts worth AU$ 9.7 billion, far exceeding what was needed to hedge its investments in Australian mining businesses.

Meanwhile, fuel-price hedging stung airlines trying to manage the risks tied to fluctuating oil prices. China Eastern and China Air, for example, acknowledged signing a large number of derivatives contracts in hopes of hedging against the ups and downs of international crude prices.

An experienced investment banker said a lot of derivatives contracts bought by SOEs were similar to those bought by their international counterparts. Japanese and American airlines, for example, use so-called the zero cost collar investment strategy to hedge risks from soaring oil prices.

When, to everyone’s surprise, oil prices fell off a cliff in August 2008, the hedging strategy led to huge losses for airlines. And Chinese airlines suffered even more than their foreign counterparts, according to a derivatives trade source.

One reason lies in the fundamental difference in hedging activities between Chinese and American airlines. China Eastern and Air China bought derivatives contracts with fatal weakness in strike prices, positions and product structures.

One derivative product that cost China Eastern and CITIC Pacific dearly is called accumulator. Airlines using this strategy expect oil prices to rise. But the strategy to buy put options and sell call options does not completely lock out upside risks. Moreover, risk positions for the airlines aggregated as oil prices dove after peaking last year.

Except for the fact that plunging oil price aggregated losses, traders found it difficult to find trading counterparts to reduce risk positions in these structured products.

In sharp contrast, America’s Southwest Airline restructured immediately its hedging contracts in the fourth quarter 2008 to eliminate risk positions, lowering hedge positions to 10 percent from 85 percent.

Also, China Eastern suffered a much larger percentage of book-value losses than its international counterparts. It reported 20 billion yuan in annual income and hedging losses as high as 6.5 billion yuan in 2008, compared with Japan Airlines, which reported operational earnings of 106 billion yuan and hedging losses of 140 million yuan for 2008.

Without a 7 billion yuan capital injection from the Chinese government, China Eastern might have filed for bankruptcy.

Devilish’ Contracts

An SASAC source told Caijing that, in his opinion, three standards can be applied to differentiate hedging and speculation. One is whether a hedged target is what a company really needs. Another is whether the hedging direction is in line with the needs of an enterprise.

A third standard is whether the scale of the hedging matches the commodity needs of an enterprise. Normally, the hedging scale should be no more than 10 percent above the commodity needs of a company.

International investment banks have become the targets for criticism over what some consider “devilish” hedging contracts – deals that cost Chinese SOEs huge losses. At the same time, it’s worth noting that the accumulator and other risky derivative products were sold mainly on East Asian markets, but were much less popular in other parts of the world.

A former international investment bank executive said, “A Beijing-based listed company suffered huge losses for derivatives trading many years ago, which bothered me greatly. So I had a negative opinion about the derivatives sales department.”

The former banker said he later discovered that Chinese enterprises signed similar derivatives contracts with many other foreign banks. Likewise, a knowledgeable source said, of the 13 banks that signed with CITIC Pacific for Australian foreign exchange forward contracts, many were solicited by the Chinese firm.

There are many reasons why such contracts attract Chinese companies. At the time of signing for a derivatives contract, for example, a ceiling price for a call option may be below the market price, allowing investors to profit immediately through the purchase of a cap gain – an earnings channel for airlines before last year’s debacles for Air China and China Eastern. Indeed, some airlines in the past earned more through derivatives contracts than from their main businesses.

Asia-Pacific Airlines Association President Andrew Herdman said, “A principle for hedging is that the company side should not profit from speculations over market trends. The purpose of hedging for airlines is to manage the disparity between oil prices at ticket sales and takeoff times.”

Zero Cost Collar investment portfolios can lower hedging costs. But China’s hedging airlines bet only that oil prices would rise, ignoring the possibility that oil prices would fall off a cliff. Afterward, they blamed the turnaround on the market, ignoring their own gambling mentality.

And at an even deeper level, the reasons for such risky decisions are tied to structural barriers at Chinese SOEs, including the typically long chain for decision-making, gaps between trader rights and responsibilities, and a lack of mechanisms for incentives and discipline.

Regulatory Responsibilities

Meanwhile, regulators are being called to task. In February, for example, former president Chen Jiulin of China National Aviation Fuel Group returned to China after completing a jail term in Singapore for an illegal hedging conviction and told Caijing, “I want my superiors to comment on my case.”

CNAF”s US$ 550 million loss stemming from derivatives trading set a record when it was uncovered in 2004. Since then, new records have been set by other Chinese SOEs, but Chen is the only executive so far punished for derivatives errors.

China’s regulators have yet to issue clear statements about last year’s derivative losses.

An article posted on the SASAC Web site in 2006 by Deputy Chairman Li Wei entitled Management over Financial Derivatives for SOEs said: “Because of a lack of in-depth understanding and the required professional knowledge about financial derivatives, some companies hastened into derivatives trading without thinking seriously about risks. This merely resulted in huge losses and painful lessons.”

Li also said, “The goal of trading derivatives for non-financial companies is risk-hedging rather than profit-earning. CNAF and Copper State Reserves sought lucrative profits rather than hedging risks for their main businesses.”

Chinese authorities have set strict rules for regulating SOE hedging activities on commodities futures. In May 2001, China Securities Regulatory Commission (CSRC) released a measure on SOE Overseas Futures Hedging Activities to allow select SOEs, as approved by the State Council, to engage in this business. Six months later, 31 SOEs obtained CRSC permission through licenses to engage in overseas futures trading.

However, regulatory supervision through business licenses is far from sufficient. Li mentioned three areas overlooked by regulators.

For one thing, the state-assets watchdog SASAC coordinated with CSRC to review overseas futures trading for SOEs, but failed to follow through. SASAC reviewed and regulated overseas futures trading activities but excluded options, financial derivatives and over-the-counter trading from their supervision framework. In addition, overseas SOEs have not been included in the supervisory framework.

This report shows that regulators understand the challenges and risks SOEs face in managing derivatives. But, regulators themselves are unsure of their responsibilities and parameters. The China Securities Regulatory Commission last year suspended a qualification review of SOEs for engaging in overseas futures trading.

A CSRC source, “CSRC does not want to bother with the qualification review matter as this is the responsibility of state assets watchdog.”

Meanwhile, an SASAC source said, “When they asked for our opinion we did not agree, thinking CSRC should take on more responsibilities.”

What’s worse is that SASAC was unable to evaluate risk positions and give advice to SOEs on how to eliminate risk exposure. According to an industry source, after oil prices fell off a cliff in the fourth quarter 2008, some companies that sought guidance from regulators were told not to expand their trading positions.

“If we had created some positions to hedge, we could have reduced losses when oil prices first slid below the floor,” said a trader. “As opening hedging positions are not free, regulators did not approve.”

So what is the future of hedging? Many agree hedging strategies will always be needed to protect returns. Others are using the word “reasonable” to describe the best approach.

One SOE executive said, “Companies should include hedging into their annual budgets by setting reasonable hedging goals, and work out policies to be reviewed by boards of directors.”

1 yuan = 14 U.S. cents

Full Article in Chinese:

No comments: