Chinese Tiger Raises Default Concerns

by: Ed Zimmer

If China isn't the 800-pound gorilla in the corner, it's definately the tiger in the kitchen. According to Reuters, China announced over the weekend that State Owned Enterprises (SOEs) will be allowed to default on commodity derivative contracts.


The report cited six foreign banks that recieved letters that the SOEs reserved the right to default on contracts. Among the SOEs signaling their potential intentions were Air China (OTCPK:AIRYY), China Eastern (NYSE:CEA) and COSCO (OTCPK:CICOF). All three have sustained "huge derivative losses since late last year". Concerns are being aired by financial circles that those holding underwater hedges may simply renege on them and walk away.

Among the major derivative providers in China are Goldman Sachs (NYSE:GS), UBS (NYSE:UBS), Morgan Stanley (NYSE:MS) and JPMorgan (NYSE:JPM). None of them provided any comment to Reuters on the letters and no banks were specifically named. Although some are questioning whether such a tactic has any basis in legality, the fact remains that this is China and fiscally, China can use this as a tool of leverage on the fiscal front.

If China carries through on its annoucement, it would set a precedent that could seriously undermine the derivatives market, at the same time impacting fractional investment as well.

Potential default was the concern that prompted the fiscal crisis in the fall of 2008 as massively intertwined derivatives and speculative CDSs and CDOs began to fall apart. If China were to succeed in walking away from derivatives contracts, it could have a significantly bigger impact on the financial world. Remember that AIG unwound many of it's investments at face value thanks to massive taxpayer infusions which helped prop up other "too big to fail" banks. It looks like some of those banks may be involved in the latest Chinese finger trap.

Disclosure: Long SLV, GLD, Physical Metals, retirement accounts