Watch Out for Falling Chinese Derivatives: Banks Run for Cover as China Hedges Fuel Bets

by Kurt Schulzke on September 23, 2009

As this story from Chinese markets shows, financial derivatives are often not what they seem.  If you plan to use derivatives to hedge risks, don’t forget the counterparty risks inherent in the derivatives themselves.

Highlighting once again the risks of doing business with state-owned Chinese companies, banks and the derivatives market took another hit on September 7 when the Chinese government encouraged state-owned airlines and shippers, including China Eastern Airlines Corp., Air China Ltd. and China Ocean Shipping (Group) Co., to legally challenge their fuel derivatives contracts with foreign banks.

The contracts were used by these companies to hedge against what they expected to be a steep rise in fuel prices.  When the prices fell — as they sometimes do in a market — the companies ended up losing millions.  The losses are premised on the assumption that the companies are legally bound by the derivative contracts. This assumption should have been questioned back in March 2009 when, according to China Daily, China’s State-owned Assets Supervision and Administration Commission (SASAC) “tightened the rules” governing State-owned enterprises’ (SOEs) use of derivatives under Chinese law.  Those who did not question then are certainly doing so now.

As the Wall Street Journal reports:

China’s government … offered public encouragement to state-owned companies challenging foreign banks over huge losses from derivative contracts …

… [The SASAC] said it supported moves by unnamed Chinese enterprises to seek recourse for their losses in structured financial derivative contracts tied to the price of oil and reserved the right to file lawsuits itself.

In early August, China Eastern Airlines Corp., Air China Ltd. and China Ocean Shipping (Group) Co. sent letters to six international investment banks warning that certain transactions “may be void, invalid or unenforceable”…

Among the banks … are Deutsche Bank AG, Goldman Sachs Group Inc., J.P. Morgan Chase & Co., Citigroup Inc. and Morgan Stanley…

The Shanghai-based [China Eastern Airlines] said in January it faced a loss of about $900 million on aviation-fuel-hedging activities. In a reminder of how volatile financial markets can be, it more recently said its position had reversed…

By stepping into oil-derivative contract disputes that have been bubbling for months, Beijing is sending a signal that its strategic interests can extend to foreign financial markets…

The SASAC highlighted in its statement that it is investigating the oil contracts in order to “safeguard state assets,” while noting the “risks and complexities” in some contracts that make them difficult to understand.

Financial policy makers in China say government leaders often don’t grasp how derivative products work and then react angrily when deals backfire… [Editorial comment: This phenomenon is not confined to Chinese government leaders.]

The article quotes Alan Wang, of Freshfields Bruckhaus Deringer LLP, for the proposition that companies entering into contracts with Chinese enterprises should “ensure that Chinese entities have necessary authorization to enter a deal, since legal challenges are often grounded in an argument that the deals weren’t permitted or were too complex [under relevant Chinese regulations].”   Wang also advises that contracts should include an international arbitration clause to ensure enforceability of awards or judgments in Chinese courts.

For a contrary view, read Dan Harris’ excellent article, China OEM Agreements. Why Ours Are In Chinese. Flat Out. Dan believes that contracts with Chinese parties should be drafted in Chinese and should direct dispute resolution to local Chinese courts.  While the derivatives contracts at issue here are not OEM agreements, it is fair to say that much of Dan’s logic crosses over.  While a non-Chinese arbitrator might uphold the derivatives contract in favor of a foreign bank, it’s far from certain that a Chinese court would enforce the arbitral award where Chinese public policy arguably demands the opposite result.

Takeaways?  Derivatives are risky whether you are hedging or speculating.  The same goes for any other kind of contract with government-owned entities — especially ones a long way from home in proudly communist countries whose cultural orientation toward “markets” has at least historically been markedly different from that of much of the rest of the world.

More details are available at the WSJ.