China May Detonate World Derivatives Panic Our Loss, Your Problem

China May Bail Out On Costly Futures Contracts

The Economist - London
9-6-9

HONG KONG -- 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.
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Chinese Sovereign Wealth Fund Dumping

Dollars For Strategic Investments Like Gold

Reports suggest that China's main sovereign wealth fund and other state entities are under pressure to invest in strategic Western assets as the country tries to offload its dollars for firmer-based wealth including gold and oil.

By Lawrence Williams

LONDON -- Several reports are coming out of China that there is pressure on state-controlled organisations - notably the country's main sovereign wealth fund, China Investment Corporation (CIC) to rapidly build investment in non-Chinese enterprises. While the CIC itself, with apparent access to some $300 billion in funds - and the possibility of more from the government - may be concentrating on hedge funds and other investment entities, there is another sector for Chinese state-owned companies looking at major investment in commodities. Indeed with the funds available as China seems to be dumping its US dollars in favour of more concrete assets, virtually no minerals sector is safe from Chinese participation.

While CIC was set up only two years ago, funded with $200 billion in initial capital, a report to the U.S. Congress noted that according to top Chinese officials, it was created to improve the rate of return on China's $1.5 trillion in foreign exchange reserves and to soak up some of the nation's excess financial liquidity. Depending on its performance with the initial allotment of $200 billion, the CIC might be allocated more of China's growing stock of foreign exchange reserves - and this has already proved to be the case.

Probably the most interesting of the recent reports of what is happening with Chinese sovereign wealth fund investment outside China has come from Paul Mylchreest's Thunder Road Report where an ex-U.S. intelligence service member is quoted. He reports that he has a friend who is in the Chinese Sovereign Wealth fund sector who says - hearsay I know and it wouldn't stand up in court - indicated that the wealth fund analysts were working all hours of the day and night trying to put investment deals together - particularly in the oil and precious metals sectors. The conclusion is that China recognises that the U.S. dollar is going to tank and it wants to convert as much of its trillions of dollars of holdings into strategic assets as possible before the collapse really takes hold.

The trouble is there is too much money available chasing too few assets - and too little time available - or such is the conclusion. As a result the Chinese government seems to be doing its utmost in trying to persuade the Chinese public to buy gold and silver by relaxing the restrictions - it's now easier to buy precious metals in China than in the U.S. - and by pushing gold and silver investment on state-owned television. If this continues the likelihood is that China will permanently overtake India as the world's biggest buyer of gold and silver, while the country's store of wealth will help shield it against further western economic collapse.

If this is indeed the case then it must be likely that the country is also building its own gold reserves - perhaps surreptitiously - through creative accounting by buying by a state entity, but not through the Central Bank itself where such sales would need to be reported. Positive for gold looking forward.

Returning to the Sovereign Wealth Funds angle though, CIC's chairman, Lou Jiwei, is reported by the WSJ as saying that investment in CIC's global portfolio for "one month this year equalled that of the whole of last year" and that given that the fund is expecting a positive return on its investments this year it may well ask the government for additional funding. Where it is going to place additional funding, who knows but there seems little doubt that China is using the western recession to buy up assets on the cheap and the funds available to do this are virtually unlimited by Western standards. But the Chinese won't buy up any old rubbish. They'll be looking for the crème de la crème.

Already, CIC has bought 17% of Canada's last real remaining diversified miner - Teck Corporation - smartly buying when the latter was only just beginning to recover from last year's collapse and it has to be likely that more minerals-strategic investments are on the cards or being negotiated, either by CIC or other state organisations. Chinalco's ultimately thwarted move into Rio Tinto would have been another such instance and the Chinese investments and takeovers of Australian miners and promises of huge funding for minerals rich African countries are other examples.

Some reckon that China will be the world's second biggest economy, overtaking Japan, within the next couple of years and will overtake the U.S. by 2030. If it continues the way it is going and the U.S. continues the way it is going, this could happen much sooner. Communism, Chinese style, is winning the war of economic dominance and soon the world will no longer rely on the dollar as its reserve currency, but the renminbi!

In an interesting, but perhaps disturbing footnote to the Thunder Road Report mentioned above, Paul Mylchreest comments that in Latin America, where he has been living for 25 years, for the first time he can remember, locals are now preferring their own currency to U.S. dollars. He goes on to finish with this comment: "If a fellow with no education, a poor diet, and inadequate medical treatment living at 3,500 metres above sea level can figure out that the US dollar is undesirable as a store of wealth, how much longer do you think it can last as the world's reserve currency."

Your point to ponder for the day.

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