Chinese Tiger Raises Default Concerns

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.

Default

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 (AIRYY.PK), China Eastern (CEA) and COSCO (CICOF.PK). 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 (GS), UBS (UBS), Morgan Stanley (MS) and JPMorgan (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

Comments

[Clive Corcoran:]

Thanks for this Interesting piece.
Presumably these must be otc derivative contracts or swaps?

Sep 02 09:54 AM

[Roger Knights:]

"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."

To put it mildly. I suspect that this newly revived threat is what's goosed gold lately.

Sep 02 11:56 AM

[notsosmart:]

you want to trust china & russia?good luck.

Sep 02 12:12 PM

[triplepoint:]

Would reduced faith in derivatives be such a bad thing? Basically its gambling. Would reduced faith in large bets at Nevada casinos be so harmful? In the case of China, there is the added issue of whether it is the state that is defaulting or merely a company (which happens to be owned by the state) defaulting.

Sep 02 08:37 PM

[goober1:]

Undermining precetent and GS is at the forefront. This is a microcosm of things to come from financial leaders. Is this what the recovery looks like?

Sep 03 02:21 PM

[Ben Gee:]

State controlled companies do get into trouble just like private companies and there should not be a difference set of rules for SCC.

Sep 03 07:30 PM