Risky business

There’s risky behavior and then there’s Russian roulette. It would appear that Chinese conglomerate CITIC Pacific has engaged in something closer to the latter. The Hong Kong-listed firm shocked the financial industry when it announced on October 20 that it might face up to US$2 billion in losses due to unauthorized currency bets.

CITIC Pacific, which saw its share price collapse as a result of the scandal and is in the process of being bailed out by its state-owned parent, has denied any illegal activity. Nonetheless, the people said to be responsible for the contracts – Leslie Chang and Chau Chi Yin, group finance director and group finance controller respectively – have resigned.

While experts stopped short of declaring the debacle a metaphor for the ills of all Hong Kong-listed Chinese firms, many believe the scandal represents just the tip of the iceberg.

"This is probably more common than one would like," said David Webb, a governance activist in Hong Kong. "But the scale on which CITIC Pacific’s bets were made, and they have said that they were unauthorized, is unprecedented."

Shortly after the announcement, brokerage CLSA released a report highlighting potential derivatives losses among companies within its coverage. Although most of the 27 firms mentioned had minimal exposure, CLSA found that the earnings of several Chinese firms – notably China Railway Group and Hunan Nonferrous – could suffer due to investments in structured products.

CITIC Pacific’s exposure, though, is on a different scale entirely – a 10% drop in the Australian dollar would amount to a whopping 150% drop in net profits, according to the report. The firm got into trouble by purchasing foreign exchange forward contracts in order to help fund a US$1.5 billion iron ore mining project in Western Australia. Under the terms of these contracts, CITIC Pacific agreed to buy about A$9 billion at a fixed price of A$1 to US$0.87. But when the value of the Australian dollar plummeted in the wake of the global credit crunch, those contracts turned loss-making.

Managing risk

While currency hedging is not unusual for firms with business interests in foreign countries, the whole endeavor is fraught with risk and requires oversight, according to K.C. Lam, director and head of Asian FX sales for CME Group in Singapore.

"There’s no such thing as a perfect hedge. Foreign exchange is very volatile right now, but that doesn’t mean you can’t manage the risk. You should be managing the risk," he said.

Furthermore, CITIC Pacific crossed the line from hedging to speculation by making asymmetric bets whereby a knock-out clause in the contracts limited the upside to A$9.44 billion, while exposing the company to unlimited losses.

"Is there a way to do heroin responsibly?  No," Webb said, pointing to the risks of this accumulated structure. "There’s no reason they should have these types of exposures. It was way more than they needed for any development of their Australian iron mines."

Patrick Chow, who covers the stock for China Everbright Research in Hong Kong, said the losses represent a failure of the company’s risk management system. But he also questioned how these trades were made in the first place: If Chang and Chau didn’t have proper authority to sign these types of contracts, why are these contracts still legally binding?

Adding to the uncertainty, although CITIC Pacific became aware of the forex exposure as early as September 7, it issued a circular on September 16 claiming to be unaware of "any material adverse change in the financial or trading position of the group." This came six weeks before the firm revealed that the potential losses might lead it into legal jeopardy, Webb said.

It will be some time before the full extent of the scandal is known. In the meantime, CITIC Pacific legacy may be a decrease in over-the-counter forex trades by companies, which are usually conducted between two parties without the benefit of transparent pricing, according to Lam.

"Corporate hedging on an exchange may see an increase from this because people want to benefit from good transparency and the best price, they know, is the same for all participants," he said.