Beijing Plays Hedge Ball - A contract should be a contract

Beijing Plays Hedge Ball. WSJ Editorial
A contract should be a contract.
WSJ, Sep 09, 2009

Beijing needs to clarify whether a contract is a contract, and fast. Recent suggestions that the government might allow or even encourage companies to challenge derivatives contracts that went against them send a bad signal to foreign companies and countries doing business with China.

The controversy stems from commodities hedges gone wrong. When fuel prices were high, airlines like China Eastern, Air China and Shanghai Airlines and shippers like China Ocean Shipping crafted derivatives contracts with foreign banks to protect the companies from even higher fuel prices. Instead the price of oil has fallen, leaving the companies on the hook for the downside risk of their hedge—a total of about $2 billion for the airlines alone, by some counts.

The companies are crying foul, and several reportedly sent a letter to the banks that sold them the derivatives suggesting they may be "void, invalid or unenforceable." Worse, the government is getting into the act. The state-owned Assets Supervision and Administration Commission, which oversees these companies, on Monday posted a statement on its Web site suggesting that Beijing might countenance efforts to sue to nullify the contracts.

China has been down this road before, pushing foreign counterparties several times over the past decade to back down from derivatives contracts that had turned against a Chinese company. In those cases, the companies or the government variously argued that the firms had been illegally speculating or had not understood the risks they were taking—or even that the people signing the papers on behalf of the Chinese companies hadn't been authorized to do so. It's hard to see how such arguments could apply to the kind of bread-and-butter fuel hedging at issue here.

Policy makers might think the government holds a lot of cards in this case, and in some respects it does. While the derivatives contracts would be tough to wriggle out of legally since they're enforceable through courts in Hong Kong, Singapore or Britain, it would be hard for the banks to collect on any judgment unless they're willing to seize planes at Heathrow or Changi airports.

The banks would have strong incentives not to try, too. Regulators in Beijing decide whether the foreign banks receive various business licenses, for instance, and state-owned enterprises constitute some of the biggest bank clients. Especially since the goal could only be to renegotiate the contracts instead of canceling them, policy makers and executives might think the banks will be willing to pay that price to continue doing business in China.

But this kind of bullying is not free. Most immediately, hedging is a risk-management tool that many Chinese companies can't afford to live without. It works on trust between counterparties that each side will hold up its end of the bargain. Already banks reportedly are demanding higher collateral for derivatives contracts like those at issue here to compensate for the loss of trust. That's an added cost of doing business not faced by other airlines that take their lumps when hedges go wrong. like Hong Kong's Cathay Pacific or America's United.

This incident will leave foreign investors wondering where China stands on its road to commercial rule of law. Following the arrests of Rio Tinto executives in a dispute over ore prices, foreign businesses already have to wonder about their physical safety if they run afoul of Chinese companies in contract negotiations. Now it appears foreign companies can be in financial danger simply for ending up on the "wrong" side of a standard off-the-shelf derivatives transaction.

Beijing officials may not realize the potential effects of this controversy on Chinese companies investing abroad. Chinese mergers and acquisitions in countries like America or Australia have been controversial in large part because politicians in those countries have worried about a lack of transparency within Chinese companies, and whether those companies would play by the rules once they hit foreign shores. Politicians already predisposed to oppose Chinese investment—and perhaps some who'd otherwise support allowing such investments—will hardly take comfort from a sign that Chinese companies won't play by the rules if it doesn't suit them. If Beijing is actively trying to dissuade foreign investment, it's on the right track.

Beijing might be responding to a political storm over the notion Chinese companies have been exploited by Western banks (one wag has called derivatives "financial opium," a charged phrase in China). Or it could be trying to bail out a few companies that made bad fuel-price bets. Or some other political motivation could be at work. Whatever the cause, though, Beijing's only smart way forward is to state clearly that a contract is a contract and that Chinese companies must abide by theirs.