When Chinese state-owned enterprises (SOEs), reportedly including China Eastern Airlines and China Ocean Shipping, said they would seek to recoup losses suffered on oil hedging contracts that went sour, a sense of fear spread among foreign banks. When the State-owned Assets Supervision and Administration Commission (SASAC) said it was backing the SOEs in their fight, the fear threatened to grow into full-fledged panic.
There’s no need for panic yet. Oil prices have risen, narrowing some of the losses, and Beijing is not likely to let the firms default on their contracts – to maintain access to foreign natural resources and markets, China needs to be seen as an investor that plays by the rules.
This is not the first time a state-owned firm has run into trouble with derivatives. In 2004, China Aviation Oil (Singapore) lost US$550 million on bad fuel-contract trades. At the time, both Beijing and the parent company tried to distance themselves from the situation. Two years later, the banks involved agreed to a settlement for much lower than the estimated losses.
Any financial support that Beijing offers will be given strategically. SOEs in key industries such as airlines are likely to bailed out, while those caught speculating may be left to their own devices – even if that means taking heavy losses.
Beijing shouldn’t stop there. It has been argued that banks bear some responsibility for pushing SOEs into contracts they didn’t understand. That is too kind to the SOEs.
The derivatives contract mess is of these companies’ own making and reflects ignorance of how derivative instruments work. SASAC must ensure that firms fully understand what they are signing, and monitor their use of derivative contracts. This is also an opportunity to make critical changes at SOEs, like developing stronger risk management guidelines.
Most importantly, SASAC must make it clear that SOEs cannot rely on bail-outs from Beijing. As long as that is an option, their possible futures as sensible, well-governed corporations are doomed. That is bad for the SOEs, bad for the development of China’s capital markets and bad for China’s international credibility.
In time, it may become clear that some short-term suffering would have been in the SOEs’ long-term best interests.